What is the true value of the investments in your portfolio? The prices of traded financial assets in markets are constantly updated as they are bought and sold. This is usually a basic and constant function of markets. This process has been overwhelmed in recent years, however, by extraordinarily loose monetary policy, cheap credit, and experimental programmes like quantitative easing.
The prices of most financial assets have consequently either been manipulated or are linked to ones that have been. Thus, markets’ pricing mechanisms have been compromised by central bank actions, making them less effective at pricing in future risks and possibilities.
False prices and exchange rates inevitably lead to misallocation of capital. Usually this is unproductive, as simply bidding up existing asset prices does not generate growth, and indeed runs the risk of the capital in question being destroyed when there is a rerating and rebalancing back to market-determined prices. The problem for investors, therefore, is that risk never goes away, it just becomes mis-priced.
As an example, the Bank for International Settlements recently stated that $9 trillion has been borrowed by various non-US individuals and entities. The trouble is that these borrowers have no dollar cash flows with which to repay these debts. The surge in the US dollar on the back of expectations of the normalisation of monetary policy by the Fed will therefore have significant consequences as risk and reward dynamics begin to recover. Creative destruction was postponed, not cancelled by easy money; on the contrary, overcapacity has been supported and increased. The irony is that inflationary policies have been having a deflationary impact.
This year, the Swiss National Bank capitulated in its efforts to link the franc to the euro in order to keep its currency from surging. This was perhaps a symbolic moment, the first crack in the facade of omnipotence that central banks have sought to maintain. The cracks have widened in the wake of the “austerity revolt” by the new Greek government, as it seeks to write off its substantial debts to the EU, the IMF and the ECB.
And it’s not just central banks feeling the pressure. Free market liberalism is clearly not working efficiently either. It is infected by crony capitalism, and hamstrung by a complex regulatory regime and creeping statism. Countries are seeking to weaken their currencies to pinch demand from their neighbours, while effectively exporting deflation.
Unfortunately, this is a zero sum game when there is a lack of an expanding “pie” of growth. It shows how tough economic times can lead governments to look inwards and attempt to implement the kind of failed protectionist policies that proved so disastrous in the 1930s. Elections in the Western world are also consequently becoming increasingly tricky to forecast.
But what does this situation mean for the average investor? It suggests that the current socio-political strain is a far from ideal backdrop against which to smoothly digest the consequences of the asset re-pricing we anticipate.
These could prove to be volatile times for investors, who will likely require a particularly well-constructed and diversified portfolio to handle the terrain. It will therefore be crucial to appropriately manage expectations for future returns. And when making investment and asset allocation changes, investors should shift to a focus on fundamental value and a proper margin of safety.
In this environment, there are dangers for investors, but also opportunities. But sticking to a sound investment strategy is never more crucial than when the going gets tough, and can allow investors to thrive and not just survive.
City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.