by Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM
“I still don't know what I was waiting for
And my time was running wild
A million dead-end streets
And every time I thought I'd got it made
It seemed the taste was not so sweet
So I turned myself to face me
But I've never caught a glimpse
Of how the others must see the faker
I'm much too fast to take that test
– David Bowie
Hannibal Ad Portas
• Just as individual desires and opinions change during different stages of life, investors should adjust accordingly as markets, technologies, and the facts change. I am not a fan of robotically following passive investment strategies that blindly ignore shifting paradigms. Investor behavior changed in the aftermath of the 2008 financial crisis in response to the extraordinary and experimental policy responses.
• There is plenty of evidence to suggest that investors, generally speaking, properly reacted to the aggressive policy actions by chasing yield and seeking greater risk. Yet, if this statement is essentially true, then why does ‘consensus thinking’ expect a conventional outcome from the extraction of unconventional monetary policy?
• Higher volatility in 2016 is a symptom of the Fed’s recent shift in policy. This shift is problematically also occurring when various global political events, and various economic and markets challenges have become more prevalent. Hence, volatility should stay elevated for a while.
• Higher volatility forces portfolios to reduce exposures to riskier, more volatile, and less liquid assets.
• Great financial challenges are ahead. Developed economies are aging quickly and their corporations and economies have never been more indebted. In aggregate, and more importantly as a percentage of GDP, the world has never been more indebted. In addition, massive US unfunded entitlement liabilities (Medicare, Medicaid, and Social Security) of around $70 trillion are quickly approaching.
• These facts are preceded by central bank actions that have effectively depleted the collective policy toolbox by pushing rates to zero (or to negative levels) and by buying $17 trillion of financial assets. The Fed might be attempting to regain some fire power by lifting rates off of ‘Zero’. Nonetheless, real solutions to these headwinds will ultimately, and most likely, have to come from political actions.
• Unfortunately, political compromise seems to be far away, so markets are reacting accordingly. Elections loom and ideologies are diverging. While the US elections are on everyone’s mind, it is too early to know what candidates will be finalists and what it will mean for markets.
• In the meantime, as I wrote earlier last week, long-dated Treasuries remain an attractive asset class.
• “It’s hard enough to keep formation amid this fallout saturation” – David Bowie
Note: The Appendix will be a waste of time for many people. It is merely a non-comprehensive list of a few influential economic and political philosophers with a mention of a few of their contributions. In a world of shifting and developing ideologies, I thought I would revisit where some important economic concepts originated. I do this to try to renew some old ideas – which some of you may use to take a deeper dive into the work of these bright and pioneering individuals.
Alterum Ictum Faciam
It is fascinating to observe the evolution of political economic thought and how it has shaped ideology and decision making over the years. Various schools of economic philosophy, no doubt, reflected characteristics of their era. Maybe compromising solutions can be revealed by remembering and collectively incorporating their work; therefore, I include this section for fun. After all most share a common underlying assumption, whereby people act purposefully to maximize their satisfactions, given their limited time, information, and resources.
• Adam Smith (1723-1790) with his 1776 book The Wealth of Nations is considered the father of modern economics. He attempted to describe the factors behind what builds nations’ wealth, touching upon the topics of labor, productivity, and free markets (the “invisible hand”). His arguments for free trade, market competition, and the morality of private enterprise remain as influential today as it was when written over 200 years ago.
• Robert Malthus (1766-1843) was a scholar in the fields of political economy and demography. He thought that the dangers of population growth precluded progress toward a utopian society, because he believed that sooner or later the population will be checked by famine or disease.
• Jeremy Bentham (1748-1832), a British economist, is associated today with the doctrine of utilitarianism. He believed that the best moral action is the one that maximizes utility or well-being of the greatest number of people. He defined utility as the aggregate pleasure after deducting suffering of all involved in any action. He was strongly in favor of extending individual legal rights.
• David Ricardo’s (1772 – 1823) most important legacy was his theory of comparative advantage which suggests that a nation should concentrate its resources solely in industries which it is most internationally competitive and then engage in trade.
• John Stuart Mill (1806-1873) drew from the ideas of Smith and Ricardo when he wrote Principles of Political Economy, which became the leading economic text of its time. Mill is credited with the idea of a free market economy. He believed an individual’s drive for self-improvement is the sole source of true freedom. He was a proponent of utilitarianism. He wrote about cycles leading to bank collapses and ensuing credit crunches.
o Mill’s book On Liberty addresses the nature and limits of the power that can be legitimately exercised by society over the individual. Mill believed that “the struggle between liberty and authority is the most conspicuous feature in the portions of history”.
o Mills discussed “social liberty” which for him meant putting limits on the ruler’s powers so that he would be unable to use his power to make decisions which could harm society. In other worlds, people should have the right to have a say in government decisions.
• Karl Marx (1818-1883) is arguably one of the most influential economists in history. He is most noted for his advocacy of socialism and communism over capitalism (which he strongly denounced). Marx believed that capitalism produced internal tension (e.g., inequality) which would lead to its self-destruction and be replaced by socialism. He believed in a process of evolution that begins with feudalism and passes through capitalism and socialism, ultimately ending in communism. He wrote The Communist Manifesto and Das Kapital.
• Alfred Marshall (1842-1924) wrote Principles of Economics, the most dominant textbook of its time. The book outlined the economic ideas of supply and demand, marginal utility and the costs of production. Marshall proposed the idea that economics was a scientific discipline that required more mathematics and less philosophy and rhetoric.
• Irving Fisher (1867 - 1947) made influential contributions to utility theory and general equilibrium. He was a pioneer in the study of intertemporal choice which led him to develop a theory of capital and interest rates.
• John Maynard Keynes (1883-1946) was an English economist whose ideas fundamentally changed the theory and practice of modern macroeconomics and the economic policies of governments. He argued against free market principles and stated that aggregate demand played the largest role in employment (not worker flexibility) and determined the overall level of economic activity. He also promoted fiscal measures as a means of correcting depressions and recessions.
• Joseph Schumpeter (1883-1950) is responsible for the idea of capitalism as a positive source of ‘creative destruction’. It implies that the economy is in a constant, cyclical state of productivity and collapse, perpetually renewed by the entrepreneur. In other words, he believed that technology and capitalism together drive change and growth. He is also one of the first to lay out a clear concept of entrepreneurship.
• Friedrich Hayek (1899-1992) is a pioneer in the theory of money and economic fluctuations. Hayek argued that the business cycle resulted from the central bank's inflationary credit expansion and its transmission over time, leading to a capital misallocation caused by the artificially low interest rates. Hayek claimed that "the past instability of the market economy is the consequence of the exclusion of the most important regulator of the market mechanism, money, from itself being regulated by the market process".
• Milton Friedman (1912-2006) was an advocate of free markets and critic of ‘Keynesian theory’. His philosophies became a major tenet of the fiscal conservative movement and helped shape the University of Chicago’s price theory philosophy. He was uncompromising in his restatement and development of Adam Smiths’ views on the merits of free markets.
• Hyman Minsky (1912-2006) elaborated on the work of Mill and Hayek in explaining how capitalist economies can be caught in speculative financial bubbles which burst with disastrous effects. He described with remarkable accuracy the stages and characteristics of boom and bust cycles. He argued against the over-accumulation of private debt in financial markets (oops).
• Daniel Kahneman (1919-present) did pioneering work in ‘behavioral economics’. His work helped to invalidate economic models that were based on past behavior and on “a rational man”. He did so by logically explaining (emotional) choices and irrational habits.
Guy Haselmann | Capital Markets Strategy
Scotiabank | Global Banking and Markets
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