Ethics, markets, economics and advice.

Few understand the dynamics of a present which is often at odds with the realities and limitations of the future.

The Institute of Economic Affairs report, “Will Flat Lining Become Normal”, discusses some important and relevant issues.  The report discussed the UK economy, but many of the issues affecting the UK economy, affect global economies too.  Its main conclusion that sustainable economic growth in the UK has fallen by over 1% (to 0.8%), is a figure that is very close to assumptions I came to in my 2010 Capitalism in Crisis 4 report.

Lower economic growth means at least two key things:

The first is that profits/earnings growth going forward will be weaker than historical rates of growth, and because of this market valuations will need to reflect lower future growth (something they were initially doing) – many historical yardsticks for addressing market valuation will no longer apply.

The second is that lower economic growth requires less capital investment and less demand for labour.  This is deflationary, depending on capacity utilisation, until the necessary readjustment to capital stock and demand for labour is complete. 

FRED Graph

Clearly as long as there are high levels of unemployment, high levels of debt, and weak income growth, the gap between what can be produced and consumed and what is will remain large. 

High debt ratios also have a greater impact on economic growth the lower the rate of growth itself – in other words, a debt to GDP ratio of x% at nominal GDP growth of 5% is a different animal from x% at 3% nominal……or worse.   Few understand the dynamics of a present which is often at odds with the realities and limitations of the future.

The trouble is, I believe, that the risks to economic growth going forward should have been well known for a considerable period of time, and clearly pre date the 2008/2009 financial crisis.  Just as market valuations moved well well ahead of levels that could be credibly sustained by even historic growth standards in the late 1990s, current market valuations in a number of economies are likely to be exposed to weak economic growth going forward and that the level of uncertainty, with respect to returns of all ilk, will likely be greater.

This leads me to the ethics of providing investment advice, in these types of environments, where there is insufficient attention to risk, where the impact of that risk on future returns is not adequately assessed and where investor expectations of return, given these risks, is not managed.   It is a difficult call, though, given that the world’s central banks have been pump priming markets themselves over a number of successive crises since the late 1990s.  

Indeed, it would seem that on one level the whole apparatus is conflicted and focussed on building an image of an alternate reality that suits agendas that are not always in investors’ best interests. 

I feel that it is the job of advisers to stand back from the conflict, but I do not think that most have the necessary tools, expertise and support to do that job.  Awareness leads to conflict and we lack awareness.  But creating awareness itself conflicts with the apparatus.

I personally felt that once markets entered late 1996/early 1997 that advice needed to consider and communicate the growing and significant risks to return and the impact of higher risk and lower return on the ability to fund withdrawals and portfolio structure.   I remember at the time how people were clinging to historical benchmarks of market risk and return even as markets moved to what were clearly stratospheric valuations and were eagerly accepting arguments that suggested high P/Es were sustainable.  

Sensible investing strategies were thrown to the dogs in the late 1990s and few were seriously addressing economic and market reality.  

Unfortunately, in the main, people are still being sold “the here and now” and not “the pragmatic and realistic future”, and you can discern this from the still high fees that investors pay and the limited centralisation of risk management functions and the automation of critical risk management frameworks.   

For portfolio managers and advisors who are deemed to be operating in their clients’ best interests, a question of ethics should arise whenever we (and this includes the organisations and institutions they work for) knowingly fail to address significant valuation/economic/market/portfolio risks to return.  

The industry is ignoring to a large degree the context in which we all invest and is, on an operational basis, assuming that it is business as usual.   This will always be the case as long as those who advise are tied to those who sell and distribute.  Therefore, the distance between providing best interests advice and self interested advice is a function of the system itself: in Canada, where product and transaction distribution holds sway the apparatus will necessarily move to eliminate factors that could stimulate awareness of ethical issues.

But, in order to be risk focussed, you need the research that assesses and quantifies the boundaries of this risk and the processes and structures that can incorporate the results into a manageable and deliverable framework.  Just being aware of risk will not help you quantify or manage it.   

Far too many “advisors” and portfolio managers still make decisions that have asset/liability outcomes without the necessary supporting research, processes and structures.    Asset allocation and how asset allocation adjusts to absolute and relative pricing, benchmarking, how portfolios relate to liability profiles, risk aversion and performance preferences, and risk/return assumption generation and asset liability modelling and management all need to be centralised, formalised and systemised.

I also express concerns and reservations over much client directed institutional research.  To this day I never forget a comment in a Barings Economic and Market report (I have still have the copy) that said “the party was only just starting”, and this was circa March/April 2000 when things were in fact just starting to fall apart.  Likewise the majority of economic analysis produced during 2007 ignored the vast structural imbalances that were to hit the system shortly after, yet focussed alarmingly on superficial economic indicators to suggest concerns were overblown.

Unfortunately we are all to varying degrees captives of a capitalist system that is most probably still off the rails – there are too many imbalances for economic growth to deliver the type of certainty that most investment planning and management is being conducted on.   Central bank support of bond markets and interest rates have skewed the risk/return equation making it extremely difficult to manage risk even through basic diversification strategies.

I would refer readers to some of the commentary in this year’s Credit Suisse Global Investment Returns Yearbook 2013 (page 13) and of course the many weekly comments by John Hussman as well as many of my own posts on this matter.   Some recent posts (here and here) on Zero Hedge also I believe have a bearing on the issue…

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