vents in recent years, both in the U.S. and
abroad, have brought home to many people the transitoriness of many of
our long-established and seemingly permanent political institutions.
Surprisingly fragile, their continued existence depends on the interest
and active support of us all, as well as the goodwill of those in
positions of authority and responsibility. In continental Europe
emotional debates about immigration threaten the stability of even the
most stable and economically powerful countries. Britain’s “Brexit”
battle has created governmental disfunction and weakened a
constitutional order dating back centuries. In the U.S.,
“tweets” spread
doubt about even the clearest constitutional strictures, while
determined factions, as feared by the Founders, hijack and render
ineffective the checks and balances the Founders put in place to prevent
their aggrandizing power. We have no doubt that ancient Rome at its
height truly did seem
“eternal” to those who lived at the time, as did
the many empires that have since come and gone to the denizens of those
long-disappeared polities. Indeed, it seems, counterintuitively, that
the more entrenched and powerful the political entity, the more
vulnerable it is to internal doubt and disruption.
One explanation for why this might be the case
was neatly summarized in a recent Financial Times piece dealing with the
chaos engulfing Britain over the
“Brexit” matter:
“insouciance about
history can induce blindness,” it warned. The relative stability of
British political institutions over centuries has imbued a feeling of
“it can’t happen here” among citizens, leading to confidence that the
country’s political traditions will continue even as events undermine
them. Worryingly, it even induces a willingness to entertain risky
ventures (as Brexit is turning out to be), under the assumption that
things
“cannot get worse,” or reach a point where the political and
institutional structures cannot recover from the blows. Those who have
lived under less stable regimes are not fooled by this way of thinking
because they know how damaging — even dangerous
—
institutional breakdown
can be. If an illusion of stability based on past experience is serving
to mask real instability in the present, people who have known only a
benign political order could be in for a shock.
A similar phenomenon takes place in the economic
sphere. Described by the late economist Hyman Minsky, extended periods
of growth and well-being encourage risk-taking as parties relax their
guards and increasingly feel that continuing prosperity will bail them
out of marginal endeavors or outright poor decisions. For example, debt
may come to be viewed more favorably as a prescription for increasing
margins and profits, under the assumption that future profit growth will
make repayment less burdensome for borrowers. (We frequently see this
thought process at work in the markets for low-grade bonds). Such
choices and the rising
“animal spirits” that accompany them can continue
for a long time without consequence, but just because nothing untoward
happens does not mean the risk is not there. Debts must be repaid
eventually. Burdens grown large increase the possibility of a
“Minsky
Moment” at the point when unexpected losses or those frightful
“black
swans” (totally unexpected macroeconomic discontinuities) upset the
speculative cart. In extreme cases, we get crises, as in 2008-2009.
Stock markets exhibit these cycles of risk as
well, as anyone who has experienced the last ten years of market
behavior has witnessed. At first indiscriminately dumped in a fit of
risk-aversion, avoided for years as painful memories lingered, then
finally embraced enthusiastically as the averages reached new heights,
equity investments since the Financial Crisis have followed a familiar
pattern. Too risky during a crisis when valuations are historically low,
high priced stocks are embraced as the only game in town,
indiscriminately, too, as index funds (which permit wagers on the market
as a whole, or at least the securities represented by the particular
index) have become seemingly too easy a choice to avoid. Fundamentally,
these moves represented a misperception of risk as being high during
market collapses, and low as prices reach new highs. Yet, when you think
of it, this doesn’t make sense. After all, during the collapse of
2008-2009, someone was buying all of those dumped shares! And those
investors subsequently enjoyed one of the longest bull markets in
history.
Have we now reached another Minsky Moment, when
risks in the system have reached a point where they outweigh the
potential rewards? Steep equity declines at the end of 2018, and
nervousness in August could be indicative of a susceptibility to
disruption. Extreme valuations of sovereign debt (exemplified by the
negative interest rates offered by a number of countries) and narrow
“spreads” across the entire bond market appear to us to be dangerous
signs of
“insouciance.” Nothing is for eternity, or, as a wise market
observer one noted,
“a bull market is not a financial institution.”
Whether it is political systems or economic activities, all are social
constructs rather than immutable laws of nature.
Shareholder Value
We experienced a fleeting moment of liminality
several weeks ago when an influential business organization, counting
among its membership the leaders of 180 major U.S. companies,
unexpectedly declared that it was abandoning the decades-long view that
a company’s sole purpose was to
“enhance shareholder value.” Companies
make business decisions that impact a wider spectrum of
“stakeholders”
—
employees, customers, communities, etc.
—
and henceforth,
the group said, corporate decision-makers should consider the needs of
these other players to a greater extent than they had in the past.
The warm and fuzzy feelings produced by this
announcement dissipated quickly when we saw that it came from a CEO
—
the
head of a large banking institution
—
known for accepting a large bonus
while the firm’s shareholders took a multi-billion dollar hit due to the
activities of a rogue employee. We doubt this greedy behavior will
instill confidence among the non-shareholder stakeholders that their
interests will be carefully looked after. Talk about inclusiveness is
nice, but actions, and, better yet, structural reforms of compensation
schemes, are necessary before real change will take place.
Commentators also pointed to another seemingly
unmovable obstacle in the way of the benefiting-all-stakeholders
concept: institutional investors. Subject to their own incentives, these
asset managers look to short-term share-price movements as absolution
for their disturbing tendency to disregard business fundamentals in
favor of following stock market winners. Pressures from large
institutional holders strongly influence managements; even executives
who have tried to take a more inclusive view of their responsibilities,
and include long-term goals in their decision-making, have been shown
the door for upsetting the institutional shareholder base.
In short, as long as the bonus culture and
incentives that focus attention on short-term share price gains remain,
we expect little change in corporate or investor behavior.
Rotation, rotation, rotation. Unlike real
estate, where a favorable fixed location positively impacts a property’s
value, financial markets can be subject to sudden shifts of the ground
that upset investment strategies and lay waste to hitherto profitable
trades, while making disappointing commitments suddenly appear
prescient. Such a shift occurred in August when massive amounts of
capital
“rotated” from the few investment stratagems that have been
working well this year (including
“momentum” and
“growth”) and also
moved away from popular economic sectors (such as interest-rate
sensitive utilities, real estate, and some consumer goods), to unloved
areas of the markets, e.g.
“value” stocks and issues with smaller market
capitalizations. New interest rate cuts appear to have catalyzed these
investor moves, but excessive interest in the favored stocks also likely
pushed many market participants to reduce their exposure to expensive
market segments.
Internal stock market convulsions were
accompanied by massive money flows into the presumed refuge of bonds,
bringing yields on some U.S. treasury securities to record lows, and
expanding the universe of securities offering negative yields up to
about $20 trillion. This move proved to be fleeting as September saw a
fixed-income sell-off. Some concerns that spooked the markets
—
trade,
currency moves, economic data — proved not as bad as anticipated, reducing
the flight-to-safety fears of just a few weeks before.
After the dust settled, the markets remained
just as elevated as before. The third quarter ended with modest gains in
the popular averages. Year-to-date market moves, at around 20% positive,
were well above average, reflecting strength in the shares of companies
in a few highly-prized industries at a time of low rates and modest
economic growth, and illustrating once again the futility of agonizing
over periodic financial market hiccups. More importantly, the
indexes
—
and most stocks
—
remain in or near record territory, making
advantageous investment a rare occurrence at this time.
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