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THE FINANCIAL SERVICES INDUSTRY IS UNIQUE. No other industry compensates its employees so generously while delivering such modest tangible value to its customers or society at large. Despite the best creative efforts of tens of thousands of extremely well-paid financiers, the former Federal Reserve Chairman Paul Volcker famously suggested that the most important financial innovation of the past 20 years was the ATM machine. In aggregate, investment expectations of even marginal added value from Wall Street and the City are misplaced, because by definition the market cannot beat itself.
But it can blow itself up. Ever since 2008 many investment practitioners have been engaged in something akin to a whodunit. Just how did we get into this mess? This book provides an answer, of sorts. Everybody did it. We all played a part.
As Lord Overstone once remarked, no warning can save people determined to grow suddenly rich. In the run-up to the Global Financial Crisis, accident-prone bankers were only doing what they always do: gambling (badly, it transpired), with other people’s money. There was also no shortage of irrational behaviour by property speculators, or homeowners, as they are sometimes called.
But the rot in the system runs deeper than just the fault lines scattered throughout the property market. After the collapse of Lehman Brothers in September 2008 most banks did not fail, because central bankers did not allow them to. The financial markets are now in thrall to these unelected monetary technocrats.
The extraordinary monetary policies that central bankers are now pursuing are destabilising all financial markets and suppressing their natural price signals.
A collective gasp on the phone
A growing property and banking crisis assumed a new dimension over the weekend of 13–14 September 2008. At just past 7am on the Saturday morning, Jamie Dimon, the Chief Executive Officer of JP Morgan, America’s largest bank, walked into his home library and dialled in to a conference call with his management team. Here is what he told them:
“ ‘You are about to experience the most unbelievable week in America ever, and we have to prepare for the absolutely worst case. Here’s the drill. We need to prepare right now for Lehman Brothers filing [for Chapter 11 bankruptcy protection]. And for Merrill Lynch filing. And for AIG filing. And for Morgan Stanley filing. And potentially for Goldman Sachs filing.’
“There was a collective gasp on the phone.”1
Lehman Brothers would indeed file for Chapter 11, shortly after midnight on Sunday 14 September 2008. But as the US authorities watched in disbelief as the global financial system started to implode on itself, they decided that the rest of Wall Street would not be allowed to follow in Lehman’s footsteps. So Merrill Lynch, the thundering herd, was swept into the welcoming arms of Bank of America. The global insurance giant AIG was rescued. Morgan Stanley was bailed out, with the help of $107 billion in loans from the US Federal Reserve (the Fed). Goldman Sachs, like the other remaining investment banks, was permitted to convert to a bank holding company, and borrow directly from the Fed – a privilege denied to Lehman Brothers in its hour of need.
The financial system was saved. For the time being, at least. But at extraordinary cost. Five years after the failure of Lehman Brothers, the Dallas Federal Reserve estimated that the full cost of the financial crisis was as much as $14 trillion – very nearly a full year of US gross domestic product.
The financial crisis wasn’t triggered by the failure of Lehman Brothers or by a shock reversal in the fortunes of any one individual firm. Lehman Brothers was merely a symptom. So, for that matter, was the decline in value of so-called sub-prime mortgages associated, in popular opinion, with Wall Street’s near-terminal collapse. Sub-prime mortgages were merely the first part of a gigantic edifice of debt to fall.
What the failure of Lehman Brothers did was threaten to derail the debt train. With highly interlinked financial markets frozen by fears over bank and counterparty risk, there was a very real threat of global Depression. A credit-driven economy requires trust between financial institutions. If that trust evaporates, trade stalls and the economy contracts. And a gigantic debt mountain absolutely requires constant economic expansion, so that all those debts can be serviced. Which is why the US government went all in to shore up Wall Street in 2008 – and why the UK government went all in to secure the future of the high street financial giants RBS and Lloyds Bank around the same time.
After four decades of ever-larger crises and bailouts, and lower interest rates (the 1987 mini-Crash; the 1998 collapse of Long-Term Capital Management; the dotcom bust of the early 2000s), we now seem to have reached the endgame. US interest rates, and indeed rates throughout the Western economies, can’t realistically go much lower. (Admittedly, at the time of writing, some 30% of all sovereign bond yields, along with several euro zone countries’ bank deposit rates, had turned negative. Like the White Queen in Alice through the Looking Glass, we must now all believe as many as six impossible things before breakfast.) Meanwhile the mountain of debt – borrowings by governments, corporations and households – has just kept on getting bigger. McKinsey estimate that since 2007, far from deleveraging, the world’s major economies have added $57 trillion to their combined debt loads – raising their debt to GDP ratios by some 17% in the process.
It was Herbert Stein that coined the appropriate adage for our current debt predicament: “If something cannot go on forever, it will stop.” The debt pyramid cannot keep growing forever. At some point, bond investors will cry “Stop.”
In January 2010, for example, the global bond fund manager Bill Gross, then in charge of $270 billion at the Pacific Investment Management Company (Pimco), warned that the UK government bond market was “a must to avoid” and “resting on a bed of nitroglycerine”. In January 2010, the UK national debt stood at just under £1 trillion. 10-year Gilts at the time yielded 4%.
They now yield less than 1%. The price of those government bonds, which moves inversely to their yield, has risen sharply higher. Yet our national debt now stands at over £1.6 trillion. While the number of Gilts outstanding has grown by 60%, the price of those Gilts has continued to shoot up. If Gilts were resting on nitroglycerine six years ago, they are now bouncing up and down on a bed of picric acid, firing napalm arrows at a dartboard made of pure antimatter.
Bond investors have not yet cried “Stop.” But each day that passes brings us closer to everyone in the bond market hearing that deafening cri de coeur. An iron law in finance is that if interest rates go up, bond prices go down. This is simple mathematics. Bond interest payments are invariably fixed, hence the designation ‘fixed income’ to describe bonds. When interest rates rise, they make those fixed income payments comparatively less attractive. To compensate bond investors, when interest rates rise, bond prices fall.
The global bond market is currently worth well over $70 trillion. The chances are you have some exposure to that $70+ trillion of debt. If you don’t, your pension fund probably does. Now ask yourself a question. After an explicit policy of suppressing bond yields, and now that global interest rates are down to their lowest levels for 5000 years,2 do we think bonds are outrageously expensive, or merely hilariously mispriced? A follow-on question: given that the size of the world’s bond markets dwarfs that of the world’s stock markets, what do we think happens to stock prices if and when $70 trillion worth of bond investors decide to head for the exits at once? We are in the process of finding out.
A new mindset for a brave new world
It is here that we should turn our attention to Japan. Japan’s stock market peaked in 1989 – the Nikkei 225 index topped out at 38,000 in December of that year. After a major property and stock market bubble during the 1980s, Japan’s markets crashed. For the next quarter of a century, Japan would wrestle with a deflationary crisis that would go on to crush prospects for growth, listed equity valuations and bond yields. Japan is dealing with that economic legacy to this day.
The Japanese monetary malaise, with an attendant policy of negative interest rates, has managed to infect much of the rest of the developed world. The modern financial environment throughout the G7 economies, with the arrival of a menagerie of strange acronyms, including QE (Quantitative Easing), ZIRP (Zero Interest Rate Policies) and NIRP (Negative Interest Rate Policies), no longer feels familiar to anyone experienced in matters of finance, no matter how long their apprenticeship or the tenure of their practical experience. Our financial markets appear to have become unhinged. As investors, we are drifting in uncharted waters and the financial system is suffused with delusional behaviour. Academics pretend that markets are rational. Fund managers pretend that they have some kind of investment edge. Financial journalists pretend to make sense of it all for the layperson. The only true wisdom is in knowing that many time-honoured principles of finance, investment and economics no longer make any sense. This is a world in which it is easy to become unsettled, unfamiliar with the new financial rules, distrustful of the future, and increasingly wary of our monetary authorities.
So join me as we lay a number of longstanding investment myths to rest. A new financial era requires a new type of mindset. To protect our investments and help them grow, we will all need to think a little differently. To prosper, we should understand, firstly, how we got here; secondly, how we will all need to challenge a number of assumptions about the way the financial world really works.
This is not meant to be just a counsel of despair, though I do intend to gesture to where some of the bodies might be buried. I also hope to provide some practical suggestions for protecting and growing an investment portfolio in what is possibly the gravest and certainly one of the most challenging financial environments that anyone has ever seen.
1. Andrew Ross Sorkin, Too Big To Fail (Penguin, 2010), p. 2.