Surviving Low Risk Premium
Summary and Investment Conclusion
The global economy is experiencing a productivity boom and savings glut simultaneously. The latter has made profits hard to come by despite strong economic growth. The global financial system has absorbed the surplus savings by marking up asset prices (mainly property) to create demand and decreasing risk premium to create profits.
The growth foundation appears fragile because it depends on a declining risk premium and rising asset prices. The global financial system has been extremely effective at maintaining this equilibrium despite the large Anglo-Saxon savings shortfall and shocks (the Iraqi War, the tripling of oil prices, and 12 rate hikes by the Fed). However, as property prices stall due to declining rental yields, we expect the global economy to slow. As long as property prices do not crash, the slowdown in the global economy should be orderly.
The era of profiting from asset appreciation appears to be coming to an end, as the risk premium is now too low to go down much further, in my view. Future profits will thus likely depend more on taking advantage of price fluctuations. This sort of zero-sum game can only be sustained if there is a constant inflow of ‘dumb’ money that chases after the latest concept. Financial markets have been full of enticing concepts in the past, and many more will likely come in the future.
Investors hoping to profit in this world will thus have to successfully “buy low and sell high”. The most dangerous strategy would be to get sucked into a concept late in the day and end up simply relying on a turnaround in a downtrend.
The Rise of Speculative Capital
Financial markets now dominate the global economy. In the currency market, trading volume exceeds the value of global trade by 20 times. In the bond, commodity and stock markets, market making activities or short-term speculative positions overwhelm trading volumes from long-term investors. Speculative capital thus dominates global financial markets.
Speculation is not a bad thing per se. Economics tells us that speculation is about guessing the economic equilibrium for a profit. As speculators compete among themselves to make the best guess, the market becomes efficient in predicting the future, which improves efficiency in capital allocation.
The standard textbook model has a unique and optimal equilibrium. The speculation that drives prices towards that equilibrium is not big enough to affect real economic activity. Neither assumption is correct in today’s world, in my view. The scale of financial speculation is such that it affects real economic activity and, hence, could create infinite equilibria in the short term.
The global economy probably has multiple long-term equilibria. What happens in the short term can determine which long-term equilibrium prevails. The financial markets are literally creating history. Between cross-border flows of capital, short-term capital in particular, and goods, the former has become dominant.
Global Savings Glut Has Led to the Rise of the Global Financial Economy
The global savings glut is the key factor in the rise of the global financial economy, in my view. The abundance of savings globally has made it more and more difficult to achieve high returns from physical investments. It has made financial speculation an attractive alternative for achieving returns. The rising demand for risk assets has made these assets less volatile, which increases their value. The first round of speculation is technically indifferent from re-rating, i.e., if demand for risk assets is permanently higher, their value should be higher. It is still too early to say whether this higher risk appetite is a cyclical or permanent phenomenon.
Aging, technology, and the industrialization of
Technology, especially the rapid development of IT, has decreased labor’s bargaining power in the global economy. It has led to income polarization worldwide. The rapid IT development has decreased labor demand, especially in the service sector, and has made manufacturing borderless. As labor becomes a price-taker in a world still with surplus labor, income polarization becomes inevitable.
High-income earners tend to have high savings rates, especially in the form of demand for financial assets. The rising ratio of financial asset value to GDP in the global economy could be partly explained by this force.
Financial Markets Maximize Growth
The global financial system has been maximizing growth by allocating money to those that can and want to spend. The main beneficiaries are the Anglo-Saxon economies,
The global financial system even anticipates problems. Asset prices are refined constantly to pre-empt potential flare-ups. The on-going strengthening of the US dollar, despite the
Whenever and wherever a problem poses a serious threat to the global economy, the global financial system seems able to prescribe the necessary medicine (usually in the form of lower or higher currency values, bond yields, or commodity prices) to contain the problem. Whenever markets worry about something, the chances are that it is a scare, as the worry itself triggers the global financial system to solve the problem. Could the global financial system ever fail in this regard? The current monetary tightening is unlikely to be the culprit, since the central banks appear to have ordered just the right amount. Global imbalances also seem an unlikely culprit in my view, as the current global savings glut appears to have given the system sufficient resources to sustain the current status quo.
The price of the growth is a declining risk premium, in my view. As long as the world keeps lowering the risk premium, financial markets can sustain growth by moving money across the world effortlessly, and I believe it would take a shock to trigger the risk reduction trade that could spell the end of the current cycle.
‘Dumb’ Money Sustains Global Financial Economy
The success of the current speculation has decreased its effectiveness as market volatilities decline. It makes speculation less successful. The relatively low returns of hedge funds in the past two years, for example, suggest the diminishing returns for speculative capital.
Wave-like market movements have become a new source of speculative profits. A typical example is the current bull market in gold. The market is full of bullish calls and speculation concerning massive buying by Middle Eastern oil money and central banks. When the market inevitably corrects, the smart money, as tends to be the case, will get out first. We are seeing the same dynamic in other markets.
‘Dumb’ money can be characterized as slow money, in my view. When a market takes off, it is initially cautious and only jumps in near the top as greed overcomes fear. On the way down, it hopes for a turnaround and pulls out when fear overpowers greed. ‘Smart’ money, by contrast, is essentially characterized by an investment strategy that takes everything with a ‘pinch of salt’ and has ‘stop-loss’ discipline in a downtrend. But, ‘smart’ money can exist only when there is sufficient ‘dumb’ money.
As ‘smart’ money keeps taking money away from ‘dumb’ money, the current equilibrium will not be sustainable in the long run; however, quantifying the timeframe for this is problematic I believe: the current global economic status quo may last for two years, five years, or 10 years. It is anybody’s guess. A shock that frightens away the ‘dumb’ money is the most likely candidate to end the current equilibrium. An outbreak of a contagious disease on a global scale, exposure of a massive financial fraud, unrest among the under privileged could upset the applecart in my view.