Batten down the hatches in case the economic storm hits

[Sheera]

Batten Down the Hatches in Case the Economic Storm Hits

Adam S. Posen
Institute for International Economics

Op-ed in the Financial Times
December 28, 2005

© Financial Times



People complain about the weather all the time, but no one does anything about it. So it goes with the potential economic storm that will be generated by the inevitable adjustment of global imbalances.

We are told repeatedly that the US current account deficit is unsustainable, that the US housing bubble and government deficits bring the day of reckoning closer, and that underlying protectionist pressures imperil the Doha round of trade negotiations, if not the entire trading system. The recommended policy responses are limited to those that would simply bring on the adjustment—contraction of US domestic demand, direct political conflict with agricultural interests, a sharp dollar decline, rising interest rates—a little bit earlier and perhaps only a little less severely.

Yet, we can at least prepare for bad weather before it hits. Imagine if knowing that New Orleans was likely someday to be hit by a powerful hurricane had actually induced reasonable preparations. Levees could have been built more strongly, evacuation plans drawn up, early warning systems made credible to suspicious citizens. No one could have prevented Katrina, but the damage from it could have been significantly reduced.

Similarly, there are policy steps that should be taken to batten down the global economy ahead of a potentially severe shock from renewed trade protectionism or dollar adjustment. Little has been done to prepare, however, because policymakers have little incentive to plan ahead. Trade negotiators and the special interests trying to constrain them benefit from pursuing a strategy of brinkmanship and so will do nothing to reduce the chances or costs of a Doha crack-up. The US and Chinese finance officials have not yet gone to the brink over revaluing the renminbi, but they are sufficiently tempted to draw lines in the sand that they, too, have little interest in lowering the stakes of economic conflict.

If the governments of the big economies wanted to learn from Katrina, though, they would take action to limit the damage that resolving the current global imbalances could bring.

First, they should strengthen economic linkages. Foreign direct investment and capital flows link economies even when trade barriers constrain commerce. The United States, the European Union, and Japan could reverse the effect of their recent decisions to block cross-border mergers by simplifying the process in three ways: agreeing on a narrow definition of what constitutes a "national security" exception; bringing accounting standards negotiations to a close, which would remove uncertainty for prospective investors; and publicly repudiating the often-invoked image of foreign investors as "vultures" who prey on employees. All this would help protect the ties between economies, encouraging continued cross-border integration of production as well as flows of capital, whatever happens with the trade round.

Second, they should enhance financial stability. Financial fragility is the primary means by which limited shocks get escalated into macroeconomic crises. Right now, with interest rate spreads at historic lows, any international adjustment that pushed up interest rates and reversed current account surpluses outside the United States could lead to sharp declines in asset values and therefore in financial sector capital. Bank supervisors in the big economies should be tightening their scrutiny and encouraging increased provisioning by banks. Financial regulators should be warning householders of the risks presented by investments that have appeared stable in recent years. Where crisis response infrastructure is lacking—as arguably the decentralized system in the European Union is—now would be a good time to rationalize.

Third, they must commit to macroeconomic stabilization. Central banks and budgetary officials could reassure the public that they will respond strongly to swings in growth (thereby avoiding the mistakes of Japanese officials in the 1990s and EU officials in recent years). In fact, if they credibly commit to stabilization policy, private-sector expectations may limit overshooting of exchange rates and investment levels. For the US Federal Reserve, the Bank of Japan, and the European Central Bank, this is a matter of adopting inflation targets that would oblige monetary policy to offset excessive movements in prices up or down; for the budgetary authorities, this means giving automatic stabilizers full room to work (for example, by the European Union reworking the stability and growth pact) or authorizing sufficient unemployment benefits in the United States and Japan. There are constructive measures that governments can and should take to prepare for the adjustment process, independent of their present politically determined approaches to trade negotiations or exchange rate policy. They probably have time to do so before the storm arrives.

The US practice of selling off assets to fund a consumption boom today may be a lousy idea for anyone who cares about future American income, but that does not make it immediately unsustainable. As 2005, 2004, and 2003 have shown, there is plenty of foreign appetite for US assets and thus room for the current account deficit to continue to expand. Given growth differentials and liquidity of investment assets, both still favoring the United States over other markets, 2006 will probably show more of the same. Instead of wondering why the hurricane has not yet hit, let us take advantage of that fact to prepare for when it comes.

[Sheera]

Funds: Is the sky falling? Not yet, but diversify

By Chet Currier Bloomberg News

WEDNESDAY, DECEMBER 28, 2005
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LOS ANGELES You want reasons to worry about the economy and the financial markets in 2006? I'll give you half a dozen.

Bubbles in various real estate markets around the world, some of which may be popping at this very moment.

Jumpy energy markets, accompanied by a chorus of voices asking, "Are we running out of oil?"

Strains on the budget of the U.S. government, and on balance sheets of U.S. households, both bedeviled by what looks like chronic spending beyond their means.

The threat of an avian flu pandemic, heightened by recent word from a UN official that the world is "losing the battle" against the virus in poultry.

Tottering pension systems and other effects of insufficient personal savings.

China.

"At present, the biggest risks are the economic meltdown scenarios, the most dangerous of which could include a period of extended and substantial deflation," says the December issue of the No-Load Fund Analyst, a newsletter produced by the fund management firm Liman/Gregory. "We view this risk as real but remote enough so that we are not aggressively hedging against it."

So goes life for the 21st-century investor, dwelling always on the edge of disaster. Risks come in bigger-than-life dimensions. To steal a line from the television comedy "Seinfeld," they're real, and they're spectacular.

The question for mutual fund investors is not whether these hazards exist but what to do about them. Denying their existence isn't an appealing option. Neither, at the other extreme, is letting them frighten you into paralyzed indecision.

The mission, then, is to muddle through somehow in the middle. Fortunately, there are strategies available to help us.

First among these is diversification. Heard for the millionth time in investment discussions, the word can sound like an airy abstraction. So let's talk specifics.

No matter what calamities do or don't befall us, stock and bond prices and interest rates can do only three things: rise, fall or stay about the same.

Using mutual funds and/or their up-and-coming competition, exchange-traded funds, investors can set up an asset allocation plan intended to take all these possibilities into account. Funds afford a crucial measure of diversification by investing across a range of individual securities.

Optimists can go heavy on stock funds, maybe even on aggressive growth-stock funds. Pessimists can go heavy on bonds or money markets. If that's not cautious enough for you, there are other options, like gold. Twenty-one precious-metals mutual funds tracked by Bloomberg have treated their faithful to an average annual gain of 30 percent over the past five years.

On the negative side, gold isn't cheap, having almost doubled in price since 2001. Sooner or later this investor haven could encounter some stormy times of its own. But hey, that's just one more risk to be managed.

There is no such thing as a perfect hedge. Sometimes diversified investors must face simultaneous trouble in a variety of markets. On the other hand, pleasant surprises are possible as well.

Note the friendly fate that awaited investors over the past year and a half who had hedged their interest rate bets by splitting their money between bond and money market funds. Returns on money funds surged from less than 1 percent to almost 4 percent, in some cases, as the Federal Reserve raised short-term interest rates.

But at the same time, bond prices did not fall as one might have expected as interest rates rose. Longer-term rates have held steady since mid-2004. From June 30, 2004, through last Wednesday, a representative bond fund, the Vanguard Long-Term Bond Index Fund, posted a healthy 8.3 percent annualized return, according to Bloomberg data.

No matter how well investors inform themselves, nobody can nail down all the long-term implications of a subject like China's rise as an economic and political force. So investing in a world populated by such imponderables comes down to a matter of risk management.

There is the threat that the rise of China will lead at some point to serious problems - fast-growing economies are always susceptible to growing pains. There is also the chance that it will keep opening new avenues to prosperity.

Diversified investors aim to take account of both possibilities. They may be especially well positioned if, as so commonly happens, what ultimately develops is a messy mixture of good and bad.


LOS ANGELES You want reasons to worry about the economy and the financial markets in 2006? I'll give you half a dozen.

Bubbles in various real estate markets around the world, some of which may be popping at this very moment.

Jumpy energy markets, accompanied by a chorus of voices asking, "Are we running out of oil?"

Strains on the budget of the U.S. government, and on balance sheets of U.S. households, both bedeviled by what looks like chronic spending beyond their means.

The threat of an avian flu pandemic, heightened by recent word from a UN official that the world is "losing the battle" against the virus in poultry.

Tottering pension systems and other effects of insufficient personal savings.

China.

"At present, the biggest risks are the economic meltdown scenarios, the most dangerous of which could include a period of extended and substantial deflation," says the December issue of the No-Load Fund Analyst, a newsletter produced by the fund management firm Liman/Gregory. "We view this risk as real but remote enough so that we are not aggressively hedging against it."

So goes life for the 21st-century investor, dwelling always on the edge of disaster. Risks come in bigger-than-life dimensions. To steal a line from the television comedy "Seinfeld," they're real, and they're spectacular.

The question for mutual fund investors is not whether these hazards exist but what to do about them. Denying their existence isn't an appealing option. Neither, at the other extreme, is letting them frighten you into paralyzed indecision.

The mission, then, is to muddle through somehow in the middle. Fortunately, there are strategies available to help us.

First among these is diversification. Heard for the millionth time in investment discussions, the word can sound like an airy abstraction. So let's talk specifics.

No matter what calamities do or don't befall us, stock and bond prices and interest rates can do only three things: rise, fall or stay about the same.

Using mutual funds and/or their up-and-coming competition, exchange-traded funds, investors can set up an asset allocation plan intended to take all these possibilities into account. Funds afford a crucial measure of diversification by investing across a range of individual securities.

Optimists can go heavy on stock funds, maybe even on aggressive growth-stock funds. Pessimists can go heavy on bonds or money markets. If that's not cautious enough for you, there are other options, like gold. Twenty-one precious-metals mutual funds tracked by Bloomberg have treated their faithful to an average annual gain of 30 percent over the past five years.

On the negative side, gold isn't cheap, having almost doubled in price since 2001. Sooner or later this investor haven could encounter some stormy times of its own. But hey, that's just one more risk to be managed.

There is no such thing as a perfect hedge. Sometimes diversified investors must face simultaneous trouble in a variety of markets. On the other hand, pleasant surprises are possible as well.

Note the friendly fate that awaited investors over the past year and a half who had hedged their interest rate bets by splitting their money between bond and money market funds. Returns on money funds surged from less than 1 percent to almost 4 percent, in some cases, as the Federal Reserve raised short-term interest rates.

But at the same time, bond prices did not fall as one might have expected as interest rates rose. Longer-term rates have held steady since mid-2004. From June 30, 2004, through last Wednesday, a representative bond fund, the Vanguard Long-Term Bond Index Fund, posted a healthy 8.3 percent annualized return, according to Bloomberg data.

No matter how well investors inform themselves, nobody can nail down all the long-term implications of a subject like China's rise as an economic and political force. So investing in a world populated by such imponderables comes down to a matter of risk management.

There is the threat that the rise of China will lead at some point to serious problems - fast-growing economies are always susceptible to growing pains. There is also the chance that it will keep opening new avenues to prosperity.

Diversified investors aim to take account of both possibilities. They may be especially well positioned if, as so commonly happens, what ultimately develops is a messy mixture of good and bad.


LOS ANGELES You want reasons to worry about the economy and the financial markets in 2006? I'll give you half a dozen.

Bubbles in various real estate markets around the world, some of which may be popping at this very moment.

Jumpy energy markets, accompanied by a chorus of voices asking, "Are we running out of oil?"

Strains on the budget of the U.S. government, and on balance sheets of U.S. households, both bedeviled by what looks like chronic spending beyond their means.

The threat of an avian flu pandemic, heightened by recent word from a UN official that the world is "losing the battle" against the virus in poultry.

Tottering pension systems and other effects of insufficient personal savings.

China.

"At present, the biggest risks are the economic meltdown scenarios, the most dangerous of which could include a period of extended and substantial deflation," says the December issue of the No-Load Fund Analyst, a newsletter produced by the fund management firm Liman/Gregory. "We view this risk as real but remote enough so that we are not aggressively hedging against it."

So goes life for the 21st-century investor, dwelling always on the edge of disaster. Risks come in bigger-than-life dimensions. To steal a line from the television comedy "Seinfeld," they're real, and they're spectacular.

The question for mutual fund investors is not whether these hazards exist but what to do about them. Denying their existence isn't an appealing option. Neither, at the other extreme, is letting them frighten you into paralyzed indecision.

The mission, then, is to muddle through somehow in the middle. Fortunately, there are strategies available to help us.

First among these is diversification. Heard for the millionth time in investment discussions, the word can sound like an airy abstraction. So let's talk specifics.

No matter what calamities do or don't befall us, stock and bond prices and interest rates can do only three things: rise, fall or stay about the same.

Using mutual funds and/or their up-and-coming competition, exchange-traded funds, investors can set up an asset allocation plan intended to take all these possibilities into account. Funds afford a crucial measure of diversification by investing across a range of individual securities.

Optimists can go heavy on stock funds, maybe even on aggressive growth-stock funds. Pessimists can go heavy on bonds or money markets. If that's not cautious enough for you, there are other options, like gold. Twenty-one precious-metals mutual funds tracked by Bloomberg have treated their faithful to an average annual gain of 30 percent over the past five years.

On the negative side, gold isn't cheap, having almost doubled in price since 2001. Sooner or later this investor haven could encounter some stormy times of its own. But hey, that's just one more risk to be managed.

There is no such thing as a perfect hedge. Sometimes diversified investors must face simultaneous trouble in a variety of markets. On the other hand, pleasant surprises are possible as well.

Note the friendly fate that awaited investors over the past year and a half who had hedged their interest rate bets by splitting their money between bond and money market funds. Returns on money funds surged from less than 1 percent to almost 4 percent, in some cases, as the Federal Reserve raised short-term interest rates.

But at the same time, bond prices did not fall as one might have expected as interest rates rose. Longer-term rates have held steady since mid-2004. From June 30, 2004, through last Wednesday, a representative bond fund, the Vanguard Long-Term Bond Index Fund, posted a healthy 8.3 percent annualized return, according to Bloomberg data.

No matter how well investors inform themselves, nobody can nail down all the long-term implications of a subject like China's rise as an economic and political force. So investing in a world populated by such imponderables comes down to a matter of risk management.

There is the threat that the rise of China will lead at some point to serious problems - fast-growing economies are always susceptible to growing pains. There is also the chance that it will keep opening new avenues to prosperity.

Diversified investors aim to take account of both possibilities. They may be especially well positioned if, as so commonly happens, what ultimately develops is a messy mixture of good and bad.


LOS ANGELES You want reasons to worry about the economy and the financial markets in 2006? I'll give you half a dozen.

Bubbles in various real estate markets around the world, some of which may be popping at this very moment.

Jumpy energy markets, accompanied by a chorus of voices asking, "Are we running out of oil?"

Strains on the budget of the U.S. government, and on balance sheets of U.S. households, both bedeviled by what looks like chronic spending beyond their means.

The threat of an avian flu pandemic, heightened by recent word from a UN official that the world is "losing the battle" against the virus in poultry.

Tottering pension systems and other effects of insufficient personal savings.

China.

"At present, the biggest risks are the economic meltdown scenarios, the most dangerous of which could include a period of extended and substantial deflation," says the December issue of the No-Load Fund Analyst, a newsletter produced by the fund management firm Liman/Gregory. "We view this risk as real but remote enough so that we are not aggressively hedging against it."

So goes life for the 21st-century investor, dwelling always on the edge of disaster. Risks come in bigger-than-life dimensions. To steal a line from the television comedy "Seinfeld," they're real, and they're spectacular.

The question for mutual fund investors is not whether these hazards exist but what to do about them. Denying their existence isn't an appealing option. Neither, at the other extreme, is letting them frighten you into paralyzed indecision.

The mission, then, is to muddle through somehow in the middle. Fortunately, there are strategies available to help us.

First among these is diversification. Heard for the millionth time in investment discussions, the word can sound like an airy abstraction. So let's talk specifics.

No matter what calamities do or don't befall us, stock and bond prices and interest rates can do only three things: rise, fall or stay about the same.

Using mutual funds and/or their up-and-coming competition, exchange-traded funds, investors can set up an asset allocation plan intended to take all these possibilities into account. Funds afford a crucial measure of diversification by investing across a range of individual securities.

Optimists can go heavy on stock funds, maybe even on aggressive growth-stock funds. Pessimists can go heavy on bonds or money markets. If that's not cautious enough for you, there are other options, like gold. Twenty-one precious-metals mutual funds tracked by Bloomberg have treated their faithful to an average annual gain of 30 percent over the past five years.

On the negative side, gold isn't cheap, having almost doubled in price since 2001. Sooner or later this investor haven could encounter some stormy times of its own. But hey, that's just one more risk to be managed.

There is no such thing as a perfect hedge. Sometimes diversified investors must face simultaneous trouble in a variety of markets. On the other hand, pleasant surprises are possible as well.

Note the friendly fate that awaited investors over the past year and a half who had hedged their interest rate bets by splitting their money between bond and money market funds. Returns on money funds surged from less than 1 percent to almost 4 percent, in some cases, as the Federal Reserve raised short-term interest rates.

But at the same time, bond prices did not fall as one might have expected as interest rates rose. Longer-term rates have held steady since mid-2004. From June 30, 2004, through last Wednesday, a representative bond fund, the Vanguard Long-Term Bond Index Fund, posted a healthy 8.3 percent annualized return, according to Bloomberg data.

No matter how well investors inform themselves, nobody can nail down all the long-term implications of a subject like China's rise as an economic and political force. So investing in a world populated by such imponderables comes down to a matter of risk management.

There is the threat that the rise of China will lead at some point to serious problems - fast-growing economies are always susceptible to growing pains. There is also the chance that it will keep opening new avenues to prosperity.

Diversified investors aim to take account of both possibilities. They may be especially well positioned if, as so commonly happens, what ultimately develops is a messy mixture of good and bad.

[Sheera]

Investing in fantasy land
By Frank Partnoy
Published: December 27 2005 19:28 | Last updated: December 27 2005 19:28

Last year at this time, market prognosticators had an easy time and not just because for 12 decades shares have always gone up in years that end in five. Their simple trick, not widely known, was to find a popular film whose title captured the spirit of investors and then to predict market changes based on the film’s themes.

Those experts realised that based on Sideways, the 2004 comedy, markets were certain to move, well, sideways. Short-term interest rates increased, but long-term rates declined. European and Japanese shares went up, but falling currencies offset those gains. The typical investor finished 2005’s wild trip bewildered, but a bit better off, just like the road trippers in the film. (A year earlier, Cheaper by the Dozen had suggested a strategy of diversification.)

This year, the movie for the markets is The Chronicles of Narnia: The Lion, The Witch and the Wardrobe based on C.S. Lewis’s book, and not only because box office receipts should at least temporarily end the downward spiral of the Walt Disney Co. It is not too much of a stretch to conclude that investors should expect from 2006 the same kinds of fanciful adventures that befall the four Pevensie siblings in the magical world of Narnia.

Most people assume that markets are dominated by tangible assets such as shares and bonds. But like little Lucy Pevensie, who finds a snowy forest instead of coats when she hides in a wardrobe, investors in 2006 will discover a bewildering array of new products, ranging from specialised exchange traded funds to virtual investments that do not actually hold any financial assets, but instead use derivatives to mimic those assets.

Just about anyone who entrusts money to a fund manager will own some of these products. In 2006, the derivatives market will grow to nearly half a quadrillion dollars (fourteen zeros), more than 10 times the world’s domestic product. Even if lobbyists are correct that derivatives are good and are used mostly for hedging, it is unclear why anyone would need to hedge the entire world’s domestic product more than once.

Institutions will continue to buy new forms of hybrid and structured investments, financial animals every bit as strange as the faun and talking beavers of Narnia. Two popular products, so-called “portable alpha” and synthetic collateralised debt obligations, attempt to replicate bond returns without owning bonds. The hot security for early 2006 is called an Ecaps, a crossbreed of shares and bonds.

Retirees will be in an even more mystifying place next year, where companies and governments that are technically bankrupt pretend they can pay pensioners by making increasingly risky bets. Pension funds today are as globally underprovisioned as mid-war Europe was when the Pevensies sent their children to stay in the country.

Next year’s markets will resemble Narnia in another way: they will be rife with conflict. In the film, the evil White Witch freezes enemies into statues and launches an interminable winter. The two leading witch candidates for 2006 are corporate managers and activist hedge funds and the battle between them will be epic.

According to one view, the central villains are self-indulgent chief executives who will reap oversized option grants, hoard shareholder capital and spurn employees, just as the White Witch belittles her dwarf and wolf servants. In 2006, the average American chief executive will be paid more than 300 times the average employee’s salary.

A contrary view blames activist hedge funds, which force managers to sacrifice long-term corporate interests at the altar of short-term shareholder value. Next year, numerous hedge funds will acquire small ownership stakes in companies and demand radical change, just as Carl Icahn, who recently bought 3 per cent of Time Warner, is pressing that company to split into pieces. On nearly 400 occasions during 2005, a hedge fund acquired 5 per cent of a company’s shares and filed papers showing it was ready to brawl. During the upcoming year, that number will double.

People might disagree about which group is evil, but both perspectives highlight the recent structural changes in markets. The issue with CEOs arises not merely from the amount of executive pay, but from its option-heavy composition; likewise, the complexities of modern financial reporting insulate CEOs from attack. Who can read the 100-plus-page financial reports of AIG, General Electric, or JPMorgan Chase and say whether those companies are well managed?

Soaring hedge fund activism arises from the evaporation of other profitable strategies, as traditional arbitrage becomes more competitive, yield curves flatten and markets become less volatile. Hedge fund managers are guided to strike at corporate managers, not by any moral sentiments, but by Adam Smith’s invisible hand. The White Witch was probably a profit maximiser, too.

The central question for 2006 will be whether shareholders are better served by hedge funds, which seek short-term profit, or corporate managers, who consider long-term value. It is a new, more sophisticated spin on an old problem: in whose interest should the company be run?

Anyone who sees markets as driven primarily by economics will favour hedge funds and will see companies as mere financial instruments that are useful only to the extent that they generate profits for shareholders. Anyone who sees markets as essentially political will favour corporate managers and will see companies as an amalgam of constituencies – shareholders, employees, customers and community – whose competing interests require the skills of an astute mediator.

But there are other possibilities, suggested by the dramatic ending of C.S. Lewis’s tale. Aslan, the lion, allows the White Witch to kill him in place of Lucy’s brother, but returns to life to avenge his own death, thereby assuring warmth and peace for Narnia. Might hedge funds make such a move, reinventing themselves as popular advocates, not merely for shareholder profit, but for all corporate constituencies? Or might corporate managers acquiesce to the goal of maximising short-term share value?

For anyone who likes not only to invest, but to think about investing, 2006 will be a year of enchantment and mystery. There is a deep magic at work in the financial markets.

The writer is a professor of law at the University of San Diego and a former banker at Morgan Stanley. He is author of Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Henry Holt/Profile)