“Risk is what’s left over when you think you’ve thought of everything.”
- Carl Richards.
By the time this financial crisis is over, a number of currently well-respected theories will, or at the very least should, be consigned to the dustbin of history. One of them is EMH: the efficient market hypothesis, which effectively states that nobody can beat the market because the market at any one time always incorporates and reflects all relevant information. Best way of refuting EMH ? The existence of Warren Buffett. Advocates of EMH would probably respond by labelling Buffett a ‘lucky monkey’: if enough asset managers flip coins for a living, they would suggest, with a straight face, a rare few are destined to call heads 100 times in a row, and to do so correctly. Sceptics of EMH would then counter by citing not just the investment track record of Buffett himself, but of Walter Schloss; of Tom Knapp and Ed Anderson of Tweedy Browne; of Bill Ruane and the Sequoia Fund; of Charlie Munger; of Rick Guerin of Pacific Partners; of Stan Perlmeter of Perlmeter Investments.. What all of these people have in common is a) a track record of uncommonly good long term investment performance and, not unrelatedly, b) a shared education in the principles of value investing as advocated by the father of the strategy, Benjamin Graham. Advocates of EMH – any left – would probably respond by labelling them all ‘lucky monkeys’, which rather stretches the boundaries of statistical improbability into an as yet undiscovered dimension. Another theory unlikely to survive this crisis and similarly destined for the dustbin of history is the fond idea that governments can successfully centrally plan economies and markets over the long run. Advocates of central planning would probably respond by citing.. well, difficult to know how they might plausibly respond, since there is no example in recorded history of a successful centrally planned economy or market. In the words of the economist Thomas Sowell,
“Socialism in general has a history of failure so blatant that only an intellectual could ignore or evade it.”
And China will be no different. The Chinese authorities are only part way through a process of appreciating that you cannot legislate your way back to a bull market. Even a one party State cannot easily inject robustness into a burst stock market bubble. The irony is that even as market commentators in the West lob squibs at China’s absurd attempts to reflate the sagging soufflé of its equity market, they turn a blind eye to the efforts of the monetary authorities in the US, Europe and Japan to print their own way back towards economic health – as opposed to currency conflagration and potential disaster.
Last week saw China throw a new grenade into the sandpit of global financial stability, in the form of a devaluation of the renminbi. This took most financial observers by surprise, coming as it did during a month traditionally associated with the summer holidays. Surely even capitalists deserve a month off ? The Chinese devaluation was not just a surprise in itself, but its relatively modest scale was also perplexing. Why introduce piecemeal tinkering on the periphery of a currency band when you could have imposed ‘shock and awe’ on the foreign exchange markets with a nice fat 10% devaluation overnight ? Some investor commentators interpreted the move as a shrewd gesture toward renminbi inclusion within the IMF’s special drawing rights, a sort of currency reserve basket. A properly freely floating renminbi would surely qualify for membership over time. Perhaps. Or perhaps the Chinese authorities simply don’t know what they’re doing and, having seen a dollar-pegged renminbi gain uncomfortably from associated strength in the US dollar even while their own stock market and economy were contracting, they panicked.
Whatever China’s motives, the practical outcome is that international investors will be less, not more, trusting of their authorities. This is in a sense only fair, in that nobody in their right minds should trust monetary authorities anywhere else, either. With a rising dollar, and commodities markets in freefall, and now a fresh impulse of deflation rushing out from China towards the rest of the world, do we really think Anglo-Saxon monetary policy rates are going to rise any time soon ? Admittedly, stranger things have happened – like the monetary authorities printing trillions of dollars out of thin air and not succeeding in generating so much as an inflationary blip, other than in financial asset prices..
The missing link between central bank money creation and “classic” inflation, of the sort that western central banks so urgently crave in order to keep their heavily indebted client governments afloat, is commercial bank lending. If commercial banks refuse to revert to their pre-crisis levels of animal spirits and rash lending, and indeed prefer to delever, with the money destruction that accompanies such delevering, all that base money creation has been for nought. For now.
Meanwhile, the implications for global investors, for once, now seem a little clearer, as if the latest Chinese fusillade in the currency wars has actually caused fog to lift from the battlefield. Crispin Odey, writing shortly before the Chinese devaluation, suggested that
“The day that China understands that it must devalue, is the day that deflation really breaks out across the world.” [Emphasis his.]
So last week’s devaluation by China may be the single shot that echoes around the world. Analyst Russell Napier indicates that
“..a sudden cessation of capital flows to emerging markets, many already reeling from falling commodity prices and declining exchange rates, could push some highly leveraged countries into default. For those familiar with such episodes previously, or even more recent events in 2008-2009, the investment lessons are clear: get long cash in general, and get long US dollars in particular.”
Commodities markets are currently caught in the crosshairs. The same goes for emerging markets, especially commodity exporters, and / or those economies with significant dollar borrowings. Elsewhere, over in equityland, companies with high amounts of leverage also look distinctly vulnerable, at least by comparison with those fortunate or astute enough to be getting by with little or no debt. In the bigger picture, the China devaluation has simply meant higher volatility, across more or less everything – so asset de-risking and asset class diversifying make as much sense as they ever have since the crisis first erupted. And to the extent that the latest Chinese deflationary wave is ultimately met with a coordinated (and peak of desperation) reflationary response by the West’s central banks, we may now be that much closer to a turn in the tide for the fortunes of (monetary) precious metals.
The markets may be broadly efficient, but they are clearly not 100% efficient. Somewhere between “broadly” and 100% lies an opportunity for the patient value investor, at the expense of the impatient or impulsive ‘growth’ investor, or of the investor who has been profitably riding equity market momentum higher, only to find himself now high and dry on the wrong side of the market altogether.
Tim Price is Director of Investment at PFP Wealth Management and co-manager of the VT Price Value Portfolio (www.pricevaluepartners.com).