The road(s) to recovery

Capitalism is in the throes of its most severe crisis of our lifetime — and then some more years.

A combination of deep global recession, global economic dislocations and effective nationalisation of large swathes of the financial sector in the world’s developed economies has deeply traumatised the balance between markets, economies and countries.

Professor Dani Rodrik of Harvard University JFK School of Government, believes it is anybody’s guess where the new balance will be struck.

So, it’s fair to say that no one knows the one road to recovery.

Investment legend and billionaire George Soros reckons the salient feature of the current financial crisis is that it was not caused by some external shock like OPEC (Organisation of the Petroleum Exporting Countries), but that the crisis was generated by the system itself.

Soros, who made his fortune exploiting the system he is now commenting on, said the global economic crisis has its roots in the financial deregulation of the 1980s and marks the end of a free-market model that has since dominated capitalist countries.

He believes the liberalisation of the finance industry begun by the Reagan administration led to a series of breakdowns, which has now forced government intervention across the world.

A recent survey of experts by The Times of London concludes that the top three individual villains at fault are Dick Fuld of Lehman Brothers, Hank Paulson, former US Secretary of the Treasury, and Alan Greenspan, former head of the Federal Reserve. But was it them... or all of us?

With hindsight, we can now see that the mixed-economy model was the crowning achievement of 20th century capitalism. The new balance that it established between state and market set the stage for an unprecedented period of social cohesion, stability and prosperity in the advanced economies that lasted until the mid-1970s.

The model became frayed from the 1980s on, and now appears to have almost completely broken down.

The reason can seemingly be expressed in one word: globalisation. Financial globalisation emanating from the 1980s has played particular havoc with the ‘old’ rules. The crisis originated in the US, the heart of the world’s financial system and the source of much of its financial innovation and globalisation. The global financial crisis (GFC) is indeed a crisis of globalisation.

Professor Rodrik contends that when Chinese-style capitalisation met American-style capitalism, with few safety valves in place, it gave rise to an explosive mix.

There were no protective mechanisms to prevent a global liquidity glut and then, in combination with US regulatory failings, from producing a spectacular housing boom and crash. Nor were there any international roadblocks to prevent the crisis from spreading.

Globalisation has hit the rocks because its champions have tried to reap the benefits without accepting enough of its disciplines.

At Davos recently, Russian Prime Minister Vladimir Putin said the entire economic growth system, where one regional centre prints money without respite and consumes material wealth, while another regional centre manufactures inexpensive goods and saves money printed by other governments, has suffered a major setback.

And Chinese Premier Wen Jiabao commented on just one side of that equation when he blamed the GFC on the inappropriate macro-economic policies of some economies and their unsustainable model of development, characterised by prolonged low savings and high consumption, excessive expansion of financial institutions in blind pursuit of profit, lack of self-discipline among financial institutions and ratings agencies ensuring distortion of risk information and asset pricing, and the failure of financial supervision and regulation to keep up with financial innovations, which allowed the risk of derivatives to build and spread.

But, argued Professor Rodrik, those who predict capitalism’s demise have to contend with one important historical fact: capitalism has an almost unlimited capacity to reinvent itself.

He said the lesson is not that capitalism is dead, it is that we need to reinvent it for a new century in which the forces of economic globalisation are much more powerful than before.

So, forget decoupling ... it’s coupling, interdependency, the G2 of the US and China, and then the rest.

This means imagining a better balance between markets and their supporting institutions at the global level. Designing the next capitalist regime will not be easy, but we do have history on our side, said Professor Rodrik.

Separately, author Robert Skidelsky and others argue that the crisis also represents a moral failure: that of a system built on debt.

At the heart of the moral failure is the worship of growth for its own sake, rather than a way to achieve a ‘good life’. As a result, economic efficiency — the means to growth — has been given absolute priority in our thinking and policy.

Some saw the impending crisis, others claim they did, and most of us failed to listen to warnings and our instincts, and held the course, hoping beyond hope. Perhaps that’s part of human nature.

Also known as Dr Doom, Dr Nouriel Roubini is an economics professor at New York University. Two-and-a-half years ago on September 7, 2006, at an International Monetary Fund meeting, Roubini announced that a crisis was brewing. He said the US was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession.

Home owners would default on mortgages, trillions of dollars of mortgage-backed securities would unravel worldwide and the global financial system would shudder to a halt. These developments, he said, would cripple major financial institutions like Fannie Mae and Freddie Mac.

Why was no one listening?

And there was Stephen Roach, respected Morgan Stanley economist.

Closer to home, there was Jonathan Pain, an Australian investment strategist. In July 2004, he brought a NINJA mortgage advert back from America and read it out at every single presentation through late 2004 and into 2005, until such time as it disintegrated. It read: “No income or job required. Personal bankruptcy? No problem.”

At every presentation in 2005 and 2006, Pain used the Robert Shiller chart of US house prices from 1890 to 2005, which showed that America was experiencing a housing bubble.

In his January 2006 Pain report, he wrote: “The imbalances in the US are simply unsustainable. The housing market is set to fall, which in turn will weaken the economy. America has spent too much and saved too little. In contrast, Asia has spent too little and saved too much. Over the next decade, these trends will, through necessity, be reversed.”

A quote he used in many presentations through 2005 and 2006 was, “Too many Americans have gorged at the debt trough for far too long”.

In his August 2007 Pain report he wrote: “My first big picture observation is that we have moved from a period of credit expansion to one of credit contraction. Growth is set to slow significantly in the months ahead and I now believe an American recession lies ahead in the next 12 months. I hope I’m wrong.”

And then in his November 2007 Pain report he wrote: “We need to ring the alarm bell on what we see in the UK and Spanish housing markets. The UK housing market has just peaked and is set for a nasty correction. Will the last one out turn the lights out!”

Why were more not saying this?

And nearly a century ago in the early 1920s, Nikolai Kondratiev, a Russian Marxist economist, proposed a theory that Western capitalist economies have long-term (50 to 60 years) cycles of boom followed by depression.

These business cycles are now called ‘Kondratiev waves’, or grand super cycles. He predicted an imminent dip, and was proved right with the Wall Street Crash in 1929. The current crisis may mean he is about 10 years out. Still, not a bad prediction for a man who died in 1938.

In the run-up to the 2007 Australian federal election, Peter Costello, as Treasurer, warned that a financial tsunami was on the way, when the Australian Stock Exchange (ASX) was near record highs. He made specific reference to the impact of the US sub-prime crisis.

Wayne Swan, then Shadow Treasurer (now Treasurer) reacted simultaneously and said that rather than desperately exploiting financial market movements for political purposes, Costello should roll up his sleeves and start tackling the inflationary pressures that he had clearly failed to contain. And Reserve Bank of Australia Governor Glenn Stevens, supported by a board of ‘eminent business people and experts’, was raising rates.

Nothing exemplifies the fallout from all of these issues better than the purchase of ABN Amro by Royal Bank of Scotland (RBS), which was finalised a little over a year ago with a payment of US$100 billion, 80 per cent in cash.

For this same amount today, RBS could buy Citibank (US$18.9 billion), Morgan Stanley (US$22.5 billion), Goldman Sachs (US$41.8 billion) and Deutsche Bank (US$15.2 billion) — and still have US$1.6 billion in change (no doubt for senior exec bonuses to celebrate a job well done). What a difference a year makes.

If that’s not enough, just take a look at the past year’s change in market capitalisation of global banks, and of the various capital markets indices.

Dominique Strauss-Kahn, head of the International Monetary Fund (IMF), believes the “whole of society” is going to suffer during the coming years, and has indicated that there is likely to be social unrest.

“We see 2009 being a really bad year with recession for most advanced economies and growth decreasing for most emerging economies,” he said.

Is it any wonder that a sequel to the movie Wall Street is being made? Is it any wonder that individuals and investors are concerned? And that Australia’s own Sam Kekovich is pointing the finger of blame directly at one group, and one group only: “overpaid fat-cat bankers”.

Fairly or not, consumers are now realising that there is a crisis, and do not believe that it’s their responsibility or fault.

In his recent Australia Day address to the nation, Kekovich emptied both barrels at the “unAustralian” behaviour of “bottom-feeding, billionaire bankers”.

“We need to return to the egalitarian values that made Australia great, embodied in our national dish: the barbecued lamb chop,” he said.

“A chop tastes the same in a designer outfit as it does in stubbies and thongs. Which reminds us you don’t need to be an overpaid, pin-striped parasite from a millionaire’s factory. The short-selling, rogue-trading, corporate crooks may disagree with me, but they can go jump. And if they don’t know the way, I’ll push them in the right direction.”

Australians have seen their superannuation and investment funds smashed, their houses worth less and their jobs under threat. They are rightly confused and concerned, and looking for answers. They certainly know that spending needs to stop.

So, where does this leave us?

What should be done by whom at a macro political and regulatory level to reform, and what are the consequences for those managing investors’ portfolios? What should our ‘reform’ be, as portfolio construction practitioners, or product providers ... and as individual investors?

I suspect that cash, low-risk, uncomplicated and vanilla will be key themes that find ready acceptance. As Anne Taylor-Fleming, noted US commentator and essayist, said today everything is getting very, very real.

Rupert Murdoch argued that governments need to take quick and drastic action because all of the world financial markets are in disarray, and whole populations are depressed and traumatised to see their life savings, including homes and retirement funds, disappearing — not to mention their jobs.

Now we have a rapid decline of real economic activity on our hands. For example, the third-quarter orders for Volvo trucks in Europe fell from 41,970 in 2007 to just 115 in 2008.

And so we have the paradox solution. The individual’s solution (to quit debt and surplus assets) is almost entirely contrary to what governments want.

Politicians clearly see that their positioning and survival depends on a correct response. Prime Minister Kevin Rudd is advocating new regulation and government intervention for financial markets, but warns that the advantages of the free market should not be thrown out with the bath water.

In arguing that the new epoch is about using state power to save itself, and holding ‘neo-liberal’ policies responsible, of which the Liberal’s Howard, Costello and now Turnbull have been the local reps, commentators believe that Rudd aims for Labor to be the ultimate political and ideological winner from the crisis. Time will tell — and the outcome will depend on how it performs in coming months.

Not that everyone’s been a loser

Andrew Lahde, a Californian-based hedge fund manager, made 888 per cent profits last year when his company Lahde Capital bet against US sub-prime mortgage assets.

Last September, Lahde decided he was rich enough to retire, closed his fund and released a letter, which became an Internet sensation. The opening paragraph begins: “Today, I write not to gloat, given the pain that nearly everyone is experiencing, that would be entirely inappropriate. Nor am I writing to make further predictions, as most of my forecasts in previous letters have unfolded or are in the process of unfolding. Instead, I am writing to say goodbye.”

Lahde then goes on to quote a colleague who said: “What I have learned about the hedge fund business is that I hate it.” He then said “I could not agree more with that statement. I was in this game for the money. The low-hanging fruit — that is, idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking. These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behaviour supporting the Aristocracy, only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America.”

Last year, John Paulson, a New York-based hedge fund manager, outsmarted Wall Street and made nearly $2 billion by betting against mortgage-backed securities.

Much derided for cashing in on others’ misery, he has shown few regrets, telling The Wall Street Journal: “I’ve never been involved in a trade that had such unlimited upside with a very limited downside.”

And then there’s McDonalds, which is selling hamburgers like hotcakes, and bookshops that stock Das Kapital, the works of Karl Marx, where sales have gone through the roof.

It is clear that the next couple of years, at least, will be difficult (to say the least) for the world economy and its citizens.

However, it’s also clear that governments and central banks around the world will do whatever it takes to deal with the crisis, via whatever means possible.

Some of what they do will prove to be wrong, and will need re-doing. There will be lasting effects and consequences. Some things will never be the same — but, over time, some will. How do we know which is which, and what the consequences are? And, what are the possible road(s) to recovery? And, what are the signposts? What are the implications for portfolios, and how do we communicate them to investors?

Graham Rich is the publisher at PortfolioConstruction Forum.

This is an edited version of an article published following the PortfolioConstruction Investment Markets Summit 2009, which was held in Sydney in February. For the full article go to www.portfolioconstruction.com.au.