Is it me or has the asset management business been slow to adapt to a postcrisis economy that only vaguely resembles the economies we’ve known throughout most of the past 60 years?
The greatest economic change has been the emergence of ubiquitous debt and its dominant potential influence on prices. In the U.S., for example, outright debt and future claims against the government have grown recently to eight times annual gross domestic product and to about 47 times the government’s annual receipts. Such leverage is not limited to the public sector. The banking system has become overleveraged, undercollateralized and underinsured: Credit card losses taken by U.S. banks are at record highs and rising; bank loans 90 days or more past due are marching ever higher; and the FDIC is currently insuring more than $6.2 trillion in deposits, with only about $10.4 billion of reserves.
In such highly leveraged economies, policy makers are determined to maintain enough funding and credit so that nominal output does not contract, in turn ensuring that the nominal prices of goods, services and even financial assets rise over time. Although the value of financial assets may go up with everything else, their already leveraged status will likely prohibit them from rising enough to overcome the vast amount of monetary inflation needed to produce nominal output growth. Real (inflation-adjusted) growth is generally accepted as only a secondary concern, and this presents a fundamental opportunity for investors — an opportunity few seem willing to exploit.
Judging from the actions of financial markets recently, investors seem most intent on hugging nominal stock or bond indexes closely, as though they were somehow shackled to the beta-oriented inertia of the last economic cycle. The reluctance to change investment practices is understandable. For most of the past 25 years, powerful forces made it entirely rational to invest broadly in financial markets. Baby boomers invested for retirement, credit grew consistently, and easy monetary conditions turbocharged the stock and bond markets. Investors that were not all in, all the time, generally suffered.
Logic dictates that we now consider a different path. That perfect storm of market conditions has passed. Populations in developed economies are older, and investors in their markets do not have the same incentives to sponsor them. And though public and private interests would like to see credit issuance remain strong (certainly if politicians and central bankers have anything to do with it), it doesn’t seem plausible for homeowner and consumer debt to expand at rates anywhere near what they were from 1981 to 2006. Further, benchmark interest rates are already historically very low and can’t continue to drop, as opposed to much of the last cycle, when market-funding interest rates declined consistently. It seems reasonable to assume that the constancy and outright magnitude of broad-based demand for financial assets will change. Mere participation in the markets won’t cut it anymore.
Despite this reality, too many investors remain focused on the markets themselves and are missing the bigger macroeconomic picture. Maybe we are hardwired to repel change. In their book Why Beautiful People Have More Daughters, Alan S. Miller and Satoshi Kanazawa explain that the natural human preference for fats and sweets was adapted in our ancestral environment because it allowed us to live longer. The authors point out that because such foods now may be easily obtained throughout all industrialized economies, “the original adaptive problem (malnutrition) no longer exists. Yet we still possess the same psychological mechanism that compels us to consume sweets and fats.”
Are market indexes our fats and sweets? After all, it seems silly to presume stock or bond markets will always offer value in real terms, especially when most investors that comprise the markets explicitly or implicitly define market pricing itself as “value.” Investment objectives and strategies based on nominal market performance today do not implicitly endorse the underlying real value of asset classes. So while hitching one’s fortunes, and risk, to yesterday’s beta wagon may ensure nominal market returns (that may be nominally positive), only the pursuit of market outperformance — or alpha — can provide investors with sufficient real returns in a debt-heavy economy. And only real returns provide investors with real benefits.
Prudence suggests that investors migrate toward a broader commitment to alpha-seeking portfolios. Investors should look to maintain or enhance their future purchasing power over time. This objective should be adopted by the majority of investors because it accurately describes our ultimate goals — to better our lots in real terms. Only alpha-seeking asset selection can provide the opportunity to achieve this goal. Investors that adapt early to this reality should have a meaningful advantage in the coming years.
Paul Brodsky is a partner with New York–based QB Asset Management Co., which specializes in macroeconomic investing.
