To safeguard against a depression, invest in the unlevered world

June 23, 2010  

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The worst case scenario today is a depression as in the 1930s. In such a scenario the non-levered places will be safest. Emerging markets will be by far the safest countries to invest in.

   Jerome Booth of Ashmore
  Jerome Booth
By Jerome Booth

When the price of a good rises people generally want less of it and the market self-equilibrates. Neo-classical economic theory assumes the same is true of asset prices. Milton Friedman consequently famously argued for not having a central bank as asset prices would self-equilibrate. However, when an asset rises people often want more of it, sometimes for a long time, sometimes many years. The result is bubbles and consequent crashes. When the crashes are big enough there is market failure requiring public sector bail-outs. Because of the asymmetry that intervention occurs on the way down but not on the way up, we get moral hazard, and with it larger and larger bubbles until we have a super bubble. We are now rediscovering macro-prudential regulation, and remembering that the Fed. was created after the bubbles of 1907 and 1893 to control asset price bubbles.

The point of telling this story, aside from the regulatory revelation being itself topical, is twofold. First it illustrates the power of a simple (and in this case flawed) idea, despite plenty of contrary evidence, that asset prices are just like goods prices.

Second, there is a parallel with the balance of payments problems historically affecting emerging markets—first too much money can come in and then it can all come out again and credit cannot be accessed at any price. In the 1980s when this was playing out in Latin America, Asia thought itself different, with the "East Asia Model," but discovered otherwise in 1997-1998. So then emerging markets ditched the idea that asset markets are self equilibrating. There are three solutions to the balance of payments problem they faced. The first best is currency appreciation. However, without a buffer of reserves one can experience significant exchange rate volatility. Hence the second best solution, adopted by many emerging markets over the last ten years, has been to build up large reserves. These are now massive, averaging 30% of GDP. Once this is achieved (and they have just been tested and found sufficient to withstand the most profound shock) one can keep them but need not build reserves further, but can go back to the first best solution. We believe this, and hence a major appreciation of emerging currencies versus the deficit old world currencies, is what is about to happen: otherwise called global rebalancing. The third best solution, capital controls, is third best because it causes significant damage and, short of much broader universal controls as in the post- WWII era, frankly do not work in the control of exchange rates for anything but the shortest period of time.

Next on the list of intellectual failure is the concept of risk. After Knight (1921), risk is where we know the probability distribution of random events; uncertainty is where we do not. We can hedge or insure risk. Rational expectations theory assumes we face risk, not uncertainty. But not only is there arguably a lot more uncertainty about than risk, but, as Keynes observed, rational investors will invest zero under conditions of uncertainty. So: Will investment in the US and Europe pick up or not?; Can the distinction between risk and uncertainty explain why rating agencies are so bad at rating sovereign risk?; Are rational expectations theory and the efficient portfolio hypothesis seriously misleading?

If we think there has been intellectual failure in economics, it is far worse in finance theory. Investors want future income, and past income is a much better approximation for this than market capitalisation. Global income is measured by GDP, yet portfolio weights are often driven by fairly arbitrary indices which only include easy to invest in assets (we pervert language by calling these "investible") although the best risk adjusted returns are often going to be in the more difficult-to-invest-in asset classes. Indices are also market cap not income based, thus giving undue weight to non-yielding assets and white elephants. We then analyze asset classes by past returns, past volatility (which is not the same as risk, a forward-looking concept) and past correlations (not causalities) to other asset classes, and assume that we can extrapolate from these characteristics into the future. The lack of causal theory is a major deficiency. There are also many principal-agent or so called agency problems in the investment industry (not restricted to subprime mortgage origination) and the main impact is to create massive investment herding.

By "being risk averse" many people actually mean doing the conventional. The dominance of backward-looking thinking in finance theory blinds many from thinking properly about future risks. This is herding, not risk reduction per se. It may reduce risk in many circumstances, but not all. Just because you have not been hit by a train whilst standing for a while facing the wrong way on a railway track does not mean it is safe. That your peers are all doing the same thing doesn’t really help your survival chances either. The worst case scenario today is a depression as in the 1930s. In such a scenario the non-levered places will be safest. Emerging markets will be by far the safest countries to invest in.

Standard risk and asset allocation models, if they engage in scenario planning at all, tend to deviate from a single central set of assumptions. Yet one should reduce dependence on standard models the more uncertainty there is, especially the more uncertainty there is about the ability of standard models to represent the future. Planning for a number of scenarios, including some very negative, requires insuring a portfolio for extreme scenarios where possible but does not mean trying to avoid immediate losses in all scenarios. Rather it means being able to recover, avoid further losses quickly and indeed make strong gains whilst others cannot.

After a couple of decades of excessive financial engineering and leverage in the developed world, the emerging world stands out as non-levered, and thus safe from the worst scenarios of painful, possibly sudden, further deleveraging. For those still invested 10% or less collectively in the various emerging market asset classes, despite emerging markets being 50% of global GDP using purchasing power parity and likely to be 50% at market prices within ten years, the question should be: Are you sure you really still want to be 90% invested in the crash zone?

Jerome Booth is head of research at Ashmore Investment Management, a $33 billion asset management firm based in London and dedicated to the emerging markets.

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