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Lisette Mermod

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Risk Reward Limited

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LM@riskrewardlimited.com

The Changing Market and what it Means for You

Sometimes I sit and wish the world was different.  That it would be predictable and logical, that changes to economies would be sensible and planned.  That all nations would recognise that they have a stake in ensuring that the global economy is robust.  Then I wake up and put on the news and realise that the world is slowly going mad.

I would like to be an optimist and say that things are going to get better, but with regret I do not believe that is the likely outcome.  I would like to believe that politicians, regulators and businessmen are all working to future to achieve a more tolerant and accepting world, but do not believe that either.

There are some clear stresses that are having significant current impacts and indeed in trying to understand these environments perhaps we gain an insight into the likely direction of events.  I will address these individually but first consider what the current environment looks like.  The global economy I generally viewed as fragile.  Some economies are experiencing modest growth whereas others are showing modest contraction.  Nothing too dramatic but it is becoming harder to do business.  Perhaps the question that should be addressed is what has caused this negative economic environment to exist and what are the consequences.

My view is firmly that the seeds of futures disasters are sown in responses to previous crises.  Too often actions are seen to be required by the political class to show that they are dealing with an issue.  Rarely is there sufficient time to properly consider all the potential outcomes and consequences leading to an optimal solution.  Rather decisions are made quickly with limited information and a lack of appreciation of the likely outcomes.    The years from 1982 to 1999 were a period of general prosperity and declining interest rates.  Indeed, long term periods of declining interest rates are often seen as being economically positive.  As interest rates drop companies and individuals are continually able to gain a benefit through paying reduced amounts for borrowing encouraging an increase in gearing and creating growth.  So, what has gone wrong and how can this change to create more general growth?

Many of you reading this will question whether growth is actually a good thing – might it not be better for everyone to stay where they are?  I argue that this is never plausible and that there is always a direction of travel.  Empires grow and decline; they are successful for a period and are then replaced.  Often the period between empires is a time of increased instability and unrest leading to uncertainty.  It is actually hard to motivate people to accept that where we are is the right place.  What do we want?  What we already have?  When do we want it?  Well we already have it…

That is never a mantra that is likely to gain general acceptance.  It will not get people out on the streets.  People will not strive to achieve what they already have.  Consequently it is always change that shouts the loudest and people that try to, for example, win elections based on where we currently are regularly are rebuffed, their message being drowned out by a cacophony of change peddled by various snake oil salesmen.

So we are in a period of change but as an economist you always look to historical precedents to indicate likely directions of travel.  The problem this time is that there are no relevant precedents.

Unintended Regulation

Regulators do not mean to cause damage.  They only want to ensure that the markets that they regulate will operate effectively.  They rarely have been involved in the wider economy and they rarely have the skills that they would require enabling them to fully appreciate the consequences of the actions that they are taking.  Indeed, they rarely even have the time to work out whether the changes that they are requiring work before they start to implement another series of changes.   This has been particularly true on the banking field where regulatory change is becoming as frequent as night following day.  Previous articles have referred to why the 2007 crisis was really borne out of the responses to the 1999 crisis.  The current period of unrest and uncertainty has its roots in the regulation which was a response to the so called financial crisis of 2007; perhaps one of the most misunderstood crises of all time.
Interest rates are cyclical and the cycle is probably around 50 years in total length.  We are leaving a period of low interest rates and would have expected to enter a market of increasing interest rates, but there is a problem.  This time we are entering this period with heightened government debt and personal gearing.  It is government debt which particulary concerns me as it continues on its relentless climb.  The consequence of such debt levels is that interest rates cannot be increased regardless of whether there is an apparent paradigm which suggest that this should be the case.
Increasing interest rates for an indebted country only serves to increase the indebtedness resulting in country downgrades and increasing the probability of default.  As an owner of a company I fully appreciate this as I am trying to degear the business – and this is of course painful.  This means that yield curves are being artificially flattened as a consequence of direct government action without any clear vision of what could happen.  The negatives include loss of currency and primary assets leading to rampant inflation.

I take the view that whilst governments might prefer for interest rates to remain low, this will not be possible in the medium term.

So did regulation cause interest rates to rise?  As we shall discuss changing regulation has changed the market appetite for certain assets which has had unintended consequences.  I am firmly of the view that the current regulatory structure has both bought forward and increased the severity of the next financial crisis.  It has created exactly the opposite outcome of its well-intentioned aims and made the world a less safe place.  As businesses and people become less certain as to their future then the time value of money changes leading to higher rates.

Misguided Regulation

In the banking industry we have become used to the idea that capital is the answer - what is the question?  Activities conducted require increasing amounts of capital in a never ending death dance of failure.  The level of capital now inhibits banks ability to achieve their primary goal of fuelling the global economy.  But then we have the dangerous liquidity rules creating another barrier to growth and distorting markets.


This is bad enough but the derivative requirements for pre and post trade posting of margin for over the counter derivatives is dangerously wrong and represents illogical analysis.  The financial crisis manifested itself in the collapse in value of securitised paper.  Financial derivatives (swaps, options and forwards) were neither the cause of the problem nor did they magnify the problem; indeed were it not for the derivatives market things could have been much worse.  Next time they will be.

The objectives of the changes were to achieve transparency yet this is best achieved through post trade notification rather than posting margin.

The central counterparties know the problem.  By creating a central credit counterparty for such a market you create a horrible systemic risk.  At the same time you change the risk profile of the underling instruments which means  that the instrument hedging is no longer achieved.  These rules are potentially extremely dangerous and I continue to hope that they will be reversed.

In a difficult market banks should be encouraged to lend.  In this way they support business and create growth and jobs.  To do this at this point in the cycle you should be reducing capital requirements to stimulate the economy.  The regulations are requiring the opposite to happen creating opportunities for  non banks to enter the market.

Changing Roles

At present many people see their job as describing what they do.  This needs to change.  Part of the reason for uncertainty is due to the speed of change.  We have been there before and we are there again.
Technology is now impacting larger employment sectors.  Processing and finance roles are being eliminated.  Call centres are becoming computers.  High Streets are becoming ghost towns.  I say none of this with enthusiasm.
The consequences of this thought process are profound.  What it suggests is that a section of the population is likely to be left behind and that a small number of people will get very rich while others suffer.  New media ensures that everyone is aware of the income differential.   This will lead to a group of people that perceive that they are disadvantaged no longer considering that they have a stake in society.  This leads to increased volatility and unrest.

Conclusion

There are a series of clear actions that need to be taken:
1.    Interest rates should not be increased until such time as global sovereign debt is decreasing
2.    Capital and liquidity levels for banks should decrease in a negative economic environment
3.    The central counterparty rules should be repealed for over the counter derivatives.

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