On Uncertain Ground

Insightful, well written summary of the economic forces that will shape business strategy in the coming years, by Howard Marks, chairman of Oaktree.

The essay touches on a number of themes in our textbook.  The first is that firms seem to be waiting until the political and economic uncertainty (Chapter 17) is resolved before they invest:

...In contrast to the preceding 28 years of pro-business and pro-free market administrations under Presidents Reagan, Bush, Clinton and Bush, today many business people detect antipathy – or, at minimum, indifference – on the part of the Obama administration, in which the private sector is little represented.  In addition, there is uncertainty and anxiety regarding the outlook for the economy, regulation and taxes.  All of these things have deterred expansion.

The second theme is the role of compensating risk differentials (chapter 9).  Given that a lot of the uncertainty is political in nature, investors have adopted so-called "macro" strategies, to buy risky securities when they perceive the political risk is about to be resolved:

This has given rise to so-called “risk-on, risk-off” investing, consisting of investors’ attempts to profit by increasing their risk exposure when they expect favorable macro developments, and decreasing it when they foresee unfavorable developments.  Since macro events determine most of the results, it’s on the macro that investors believe they should spend their time.

Finally, there is a really good description of the formation of the financial asset bubble:

In the 1980s and ’90s, everything went right.  Economic growth was strong.  Companies thrived.  There were great gains in productivity and technology.  Profits rose dramatically.  Interest rates declined.  Inflation was quiescent.  Equities soared.  Houses and 401k accounts appreciated, producing a positive “wealth effect.”  The world was largely at peace.  All of this contributed to positive psychology, feeding back to further spur economic strength in a classic virtuous circle.  Was this a period in which favorable outcomes were entirely dependable, or just one in which the underlying processes met up with good luck, producing favorable outcomes?  And if the latter, were the results better than people should have expected to continue? 

Regardless, people did extrapolate them.  When stocks returned 20% a year in the 1990s, rather than the normal 10%, investors ratcheted up their return expectations for the subsequent years, and with them their allocations to equities.  Everyone knows that if you reach into a bag containing both black and white balls and pull out ten white ones in a row, the probability has increased that the next one will be black [PROFESSOR NOTE:  The author is using the statistical metaphor, sampling without replacement, that you cannot keep drawing white balls out of a hat, to explain his belief that the downside risk is bigger.  This is not the only one he could have used.  Regression towards the mean suggests that high returns in one period are "outliers" and we should not expect them to continue].  But in the investment world, events like that serve to convince people that there are only white balls – favorable outcomes – in the bag.  That’s part of the illogical, emotional thinking that makes for bull markets and bubbles.  So by the time the late 1990s rolled around, many investors had concluded that the world was a benign place in which profits were inevitable.  That is, that there was little risk or uncertainty.

And its aftermath, deleveraging:

Few debtors can tap the capital markets today to the same extent they could five or ten years ago.  In a radical turn of events, lenders now appear to care about borrowers’ ability to repay, and they find some of their customers less than creditworthy.  Since almost no borrowers actually have the ability to pay off their debts, this has led to credit difficulties ranging from home foreclosures, to municipal bankruptcies in the U.S., to debt crises in peripheral Europe. 

American consumers seem to have concluded that they should owe less (or have found that they can’t borrow as much).  For whatever reason, the savings rate has risen, suggesting a decline in the propensity to spend all one makes and more.  All around the world, there’s movement on the part of borrowers – sometimes voluntary and sometimes involuntary – toward austerity (reducing the excess of spending over incomes) or even delevering (spending less than you make and using the surplus to pay down debt).