A glimmer of hope...

In recent months we have been bombarded with a spate of bad or negative economic news as the fallout from the global financial crisis became real. Now today The Organisation for Economic Co-operation and Development (OECD) has revised its World Economic Outlook upwards for the first time in two years and concludes that the global economic downturn is nearing a bottom.

Financial Times reported as follows:

In its report the OECD revised its growth forecast for 2009 to a decline of 4.1 per cent, down from a contraction of 4.3 per cent. It said that in 2010, it expects very modest growth where earlier it expected none.

“OECD activity now looks to be approaching its nadir, following the deepest decline in post-war history,” the report said, adding caveats that the recovery is “likely to be both weak and fragile for some time”. Moreover, it warned that the negative economic and social consequences of the crisis would be long-lasting.

“Yet, it could have been worse. Thanks to a strong economic policy effort an even darker scenario seems to have been avoided,” the OECD concluded.

Equally, financial conditions are likely to remain constrained for some time and the actual bottom of the recession is will probably not be reached until the second half of this year. Moreover, unemployment within the OECD will not peak until next year.

However, the OECD said the risks to growth have become more balanced, thanks to massive policy intervention on the fiscal and monetary fronts and quick efforts to stabilise financial institutions.

Already, growth appears to be under way in most non-OECD countries, especially China. There are also signs that the contraction in the US may be near the bottom as well as signals that Japan may be coming to the end of its trade-induced contraction.

The report cautions governments against sudden withdrawal of fiscal stimulus, a likely response given the build-up of apparently unsustainable levels of public borrowing. “However, it is necessary to balance concerns about fiscal sustainability with the need to avoid an overly rapid phase-out of fiscal support,” the report said.

It noted that some countries including Germany, Canada and some Nordic countries may have scope to increase fiscal stimulus because they have relatively low levels of debt. But Japan, Italy, Greece, Iceland and Ireland have no such leeway.

The drag on output from the sharp fall in housing activity across all economies should peak this year and house prices are falling in all OECD countries for which there is data, except Switzerland, the report noted. The report pointed to evidence across the OECD that the contraction phase of past house price cycles is typically five years, and that the drag on consumption from falling housing values are likely to be most marked in countries where the ability to extract cash from a rise in house prices was greatest.

Meanwhile, the fall in world trade seems to have moderated after the collapse in the fourth quarter of 2008 and first quarter of 2009. Nonetheless, OECD exports and imports have most likely been falling at double-digit rates in the second quarter, the decline being less pronounced for the non-OECD area.

For 2009, world trade, in real terms including non-OECD states, is expected to contract by 26 per cent and recover modestly in 2010 to expand by 2 per cent.

What we know and don't know

How will history judge the current economic turmoil? For sure, there are a lot of unknowns how the economic and political order of the world will develop from the current crisis, yet there are some aspects we do know enough about to make convincing statements and predictions. Martin Wolf, chief economics commentator for the Financial Times, recently wrote the following article wherein he summarises the major trends we have seen so far:

On the economy, we already know five important things. First, when the US catches pneumonia, everybody falls seriously ill. Second, this is the most severe economic crisis since the 1930s. Third, the crisis is global, with a particularly severe impact on countries that specialised in exports of manufactured goods or that relied on net imports of capital. Fourth, policymakers have thrown the most aggressive fiscal and monetary stimuli and financial rescues ever seen at this crisis. Finally, this effort has brought some success: confidence is returning, the global economy is “around the inflection point” - the economy is now declining at a declining rate.

We can also guess that the US will lead the recovery. The US is again the advanced world’s most Keynesian country. We can guess, too, that China, with its massive stimulus package, will be the most successful economy in the world.

Unfortunately, there are at least three big things we cannot know. How far will exceptional levels of indebtedness and falling net worth generate a sustained increase in the desired household savings of erstwhile high-spending consumers? How long can current fiscal deficits continue before markets demand higher compensation for risk? Can central banks engineer a non-inflationary exit from unconventional policies?

On finance, confidence is returning, with spreads between safe and risky assets declining to less abnormal levels and a (modest) recovery in markets. The US administration has given its banking system a certificate of reasonable health. But the balance sheets of the financial sector have exploded in recent decades and the solvency of debtors is impaired.

We can guess that finance will make a recovery in the years ahead. We can guess, too, that its glory days are behind it for decades, at least in the west. What we do not know is how far the “deleveraging” and consequent balance-sheet deflation in the economy will go. We also do not know how successfully the financial sector will see off attempts to impose a more effective regulatory regime.

What about the future of capitalism? It will survive. The commitment of both China and India to a market economy has not altered. People on the free-market side would insist the failure should be laid more at the door of regulators than of markets. There is great truth in this: banks are, after all, the most regulated of financial institutions. But this argument will fail politically. The willingness to trust the free play of market forces in finance has been damaged.
We can guess, therefore, that the age of a hegemonic model of the market economy is past. Countries will, as they have always done, adapt the market economy to their own traditions. But they will do so more confidently.

Less clear are the implications for globalisation. We know that the massive injection of government funds has partially “deglobalised” finance, at great cost to emerging countries. We know, too, that government intervention in industry has a strong nationalist tinge. We know, as well, that few political leaders are prepared to go out on a limb for free trade.

Most emerging countries will conclude that accumulating massive foreign currency reserves and limiting current account deficits is a sound strategy. This is likely to generate another round of destabilising global “imbalances”.

The state, meanwhile, is back, but it is also looking ever more bankrupt. Ratios of public sector debt to gross domestic product seem likely to double in many advanced countries: the fiscal impact of a big financial crisis can, we have been reminded, be as costly as a large war.

This, then, is a disaster that governments of slow-growing advanced economies cannot afford to see repeated in a generation. The state is back, therefore, but it will be the state as intrusive busybody, not big spender.

Last but not least, what does the crisis mean for the global political order? Here we know three important things. The first is that the belief that the west at least knew how to manage a sophisticated financial system has perished. The crisis has damaged the prestige of the US, in particular, pretty badly, although the tone of the new president has certainly helped. The second is that emerging countries and, above all, China are now central players, as was shown in the decision to have two seminal meetings of the Group of 20 leading nations at head of government level. The third is that efforts are being made to refurbish global governance, notably in the increased resources being given to the International Monetary Fund and discussion of changing country weights within it.

We can still only guess at how radical the changes in the global political order will turn out to be. The relationship between the US and China will become more central, with India waiting in the wings. The relative economic weight and power of the Asian giants seems sure to rise. Europe, meanwhile, is not having a good crisis. Its economy and financial system have proved far more vulnerable than many expected.

What then is the bottom line? My guess is that this crisis accelerated some trends and has proved others – particularly those in credit and debt – unsustainable. It has damaged the reputation of economics. It will leave a bitter legacy for the world.

To paraphrase what people said on the death of kings: “Capitalism is dead; long live capitalism.”

How to regulate the financial markets...

George Soros is an astute investor. To discard his sound advice is done at one's own peril. Recently he wrote a piece in the Financial Times how he thinks the financial industry should be regulated.

I am not an advocate of too much regulation. Having gone too far in deregulating – which contributed to the current crisis – we must resist the temptation to go too far in the opposite direction. While markets are imperfect, regulators are even more so. Not only are they human, they are also bureaucratic and subject to political influences, therefore regulations should be kept to a minimum.

Three principles should guide reform. First, since markets are bubble-prone, regulators must accept responsibility for preventing bubbles from growing too big. Alan Greenspan, the former chairman of the Federal Reserve, and others have expressly refused that responsibility.

If markets cannot recognise bubbles, they argued, neither can regulators. They were right and yet the authorities must accept the assignment, even knowing that they are bound to be wrong. They will, however, have the benefit of feedback from the markets so they can and must continually recalibrate to correct their mistakes.

Second, to control asset bubbles it is not enough to control the money supply; we must also control the availability of credit. This cannot be done with monetary tools alone – we must also use credit controls such as margin requirements and minimum capital requirements.

Currently these tend to be fixed irrespective of the market’s mood. Part of the authorities’ job is to counteract these moods. Margin and minimum capital requirements should be adjusted to suit market conditions. Regulators should vary the loan-to-value ratio on commercial and residential mortgages for risk-weighting purposes to forestall real estate bubbles.

Third, we must reconceptualise the meaning of market risk. The efficient market hypothesis postulates that markets tend towards equilibrium and deviations occur in a random fashion; moreover, markets are supposed to function without any discontinuity in the sequence of prices. Under these conditions market risks can be equated with the risks affecting individual market participants. As long as they manage their risks properly, regulators ought to be happy.

But the efficient market hypothesis is unrealistic. Markets are subject to imbalances that individual participants may ignore if they think they can liquidate their positions. Regulators cannot ignore these imbalances. If too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or, worse, a collapse. In that case the authorities may have to come to the rescue. That means that there is systemic risk in the market in addition to the risks most market participants perceived prior to the crisis.

The securitisation of mortgages added a new dimension of systemic risk. Financial engineers claimed they were reducing risks through geographic diversification: in fact they were increasing them by creating an agency problem. The agents were more interested in maximising fee income than in protecting the interests of bondholders. That is the verity that was ignored by regulators and market participants alike.

Finally, I have strong views on the regulation of derivatives. The prevailing opinion is that they ought to be traded on regulated exchanges. That is not enough. The issuance and trading of derivatives ought to be as strictly regulated as stocks. Regulators ought to insist that derivatives be homogeneous, standardised and transparent.

Custom-made derivatives only serve to improve the profit margin of the financial engineers designing them. In fact, some derivatives ought not to be traded at all. I have in mind credit default swaps. Consider the recent bankruptcy of General Motors. Some bondholders owned CDS and stood to gain more by bankruptcy than by reorganisation. It is like buying life insurance on someone else’s life and owning a licence to kill him. CDS are instruments of destruction that ought to be outlawed.

A new era of regulation...

Pres. Barack Obama announced on Wednesday fundamental changes to the regulatory environment in which U.S. businesses operate in the financial industry. Financial Times reported as follows:

Big US companies ranging from Wall Street banks to insurers, investment groups and General Electric on Wednesday faced fundamental changes in the business environment as President Barack Obama proposed what could be the biggest regulatory revamp since the 1930s.

The plan, which still must win congressional approval, includes not only traditional lenders, but any company with significant financial operations, such as GE.

Remuneration and profits at Wall Street and beyond could be hit by the reforms, which would see the administration attempt to tighten capital and leverage rules at global banks.

The administration sees the new rules as a rejection of Alan Greenspan light-touch approach.

“A culture of irresponsibility took root from Wall Street to Washington to Main Street,” said Mr Obama on Wednesday. Mr Obama said he did not undertake intervention into the economy lightly. “We are called upon to recognise that the free market is the most powerful generative force for our prosperity – but it is not a free licence to ignore the consequences of our actions,” he said.

Corporate experts said the extension of the Fed’s powers would change the playing field for companies with finance operations, including Ford and General Motors, and others. It also could affect the strategies of companies such as retailer Wal-Mart, which had considered entering the financial sector.

Large private equity groups and hedge funds such as Blackstone and Fortress could also come under the Fed’s purview if their size and importance to the economy continues to grow.

The proposals attempt to bring transparency to previously opaque areas of financial markets, such as over-the-counter derivatives trading, and give the government unprecedented power to seize failing institutions.

The new powers are intended as a response to the authorities’ inability to deal with the failure of large financial companies, such as AIG and Lehman Brothers, which were systemically important but remained outside the purview of the main US banking regulators.

Only a handful of winners in the long run

Every year the top-performing investment funds are crowned for their recent successes. What do these laurels actually mean for the ordinary investor? Should you invest or switch your investments to these star performing funds? The latest research indicates that this is not necessarily such a great idea.

Mark Hilbert wrote the following article, The Prescient are Few, appearing in The New York Times on July 13, 2008:

How many mutual fund managers can consistently pick stocks that outperform the broad stock market averages — as opposed to just being lucky now and then?

Countless studies have addressed this question, and have concluded that very few managers have the ability to beat the market over the long term. Nevertheless, researchers have been unable to agree on how small that minority really is, and on whether it makes sense for investors to try to beat the market by buying shares of actively managed mutual funds.

A new study builds on this research by applying a sensitive statistical test borrowed from outside the investment world. It comes to a rather sad conclusion: There was once a small number of fund managers with genuine market-beating abilities, as judged by having past performance so good that their records could not be attributed to luck alone. But virtually none remain today. Index funds are the only rational alternative for almost all mutual fund investors, according to the study’s findings.

The study, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimating Alphas,” has been circulating for over a year in academic circles. The statistical test featured in the study is known as the “False Discovery Rate,” and is used in fields as diverse as computational biology and astronomy. In effect, the method is designed to simultaneously avoid false positives and false negatives — in other words, conclusions that something is statistically significant when it is entirely random, and the reverse.

The researchers applied the method to a database of actively managed domestic equity mutual funds from the beginning of 1975 through 2006. To ensure that their results were not biased by excluding funds that have gone out of business over the years, they included both active and defunct funds. They excluded any fund with less than five years of performance history. All told, the database contained almost 2,100 funds.

The researchers found a marked decline over the last two decades in the number of fund managers able to pass the False Discovery Rate test. If they had focused only on managers running funds in 1990 and their records through that year, for example, the researchers would have concluded that 14.4 percent of managers had genuine stock-picking ability. But when analyzing their entire fund sample, with records through 2006, this proportion was just 0.6 percent — statistically indistinguishable from zero, according to the researchers.

This does not mean that no mutual funds have beaten the market in recent years, Professor Russ Wermers said. Some have done so repeatedly over periods as short as a year or two. But, he added, “the number of funds that have beaten the market over their entire histories is so small that the False Discovery Rate test can’t eliminate the possibility that the few that did were merely false positives” — just lucky, in other words.

Professor Wermers says he was surprised by how rare stock-picking skill has become. He had “generally been positive about the existence of fund manager ability,” he said, but these new results have been a “real shocker.”

Why the decline? Professor Wermers says he and his co-authors suspect various causes. One is high fees and expenses. The researchers’ tests found that, on a pre-expense basis, 9.6 percent of mutual fund managers in 2006 showed genuine market-beating ability — far higher than the 0.6 percent after expenses were taken into account. This suggests that one in 10 managers may still have market-beating ability. It’s just that they can’t come out ahead after all their funds’ fees and expenses are paid.

Another possible factor is that many skilled managers have gone to the hedge fund world. Yet a third potential reason is that the market has become more efficient, so it’s harder to identify undervalued or overvalued stocks. Whatever the causes, the investment implications of the study are the same: buy and hold an index fund benchmarked to the broad stock market.

Professor Wermers says his advice has evolved significantly as a result of this study. Until now, he says, he wouldn’t have tried to discourage a sophisticated investor from trying to pick a mutual fund that would outperform the market. Now, he says, “it seems almost hopeless.”