Not so expert

Buttonwood, The Economist

ASK enough people for advice, they say, and you will eventually find someone who will tell you what you want to hear. But the need for advice burns so strongly that people become blind to its quality. There is a remarkable tendency to trust experts, even when there is little evidence of their forecasting powers. In his book “Expert Political Judgment”, Philip Tetlock shows that political forecasters are worse than crude algorithms at predicting events. The more prominent the expert (ie, the more they were quoted by the news media), the worse their records tended to be. There is also an inverse relationship between the confidence of the individual forecaster and the accuracy of their predictions.

The remarkable tendency for individuals to rely on expert advice, even when the advice clearly has no useful component, was neatly illustrated in a recent academic paper* about an Asian experiment. Undergraduates in Thailand and Singapore were asked to place bets on five rounds of coin flips. The participants were told that the coins came from fellow students; that these would be changed during the process; that the coin-flipper would be changed every round; and that the flippers would be participants, not experimenters. Thus there was a high likelihood that the results would be random.

Taped to the desk of each participant were five envelopes, each predicting the outcome of the successive flips. Participants could pay to see the predictions in advance, but they saw them free after the coin toss had occurred.

When the initial prediction turned out to be correct, students were more willing to pay to see the next forecast. This tendency increased after two, three and four successful predictions. Furthermore, those who paid in advance for predictions placed bigger bets on subsequent coin tosses than those who did not.

Paying for financial advice might not seem quite as bizarre as paying for coin-toss predictions, but there are some similarities. Nobody can reliably forecast the short-term outlook for economies or stockmarkets; Warren Buffett, the world’s most successful long-term investor, thinks it is not worth trying to do so. But plenty of economists and strategists earn a good living doing just that. The average active-fund manager fails to beat the stockmarket index; no reliable way has been found for selecting above-average managers in advance. Yet investors are still willing to pay for the services of active managers.

The sheer complexity of modern financial markets and the torrent of information that is published each day are a boon to the providers of financial advice. Investors may feel that they simply do not have the time to analyse all the data, and they therefore need to rely on the advice of professionals. This is true even if they think the markets are a “rigged game” played for the benefit of insiders; it still makes sense for them to pay for an insider’s view.

There may be another, psychological, reason why investors want to pay for advice: the avoidance of regret. If you choose to put all your money into technology stocks on the back of your own research, and such stocks collapse, you only have yourself to blame. But if you have listened to the advice of an expert, then the decision is not your fault.

Some financial advice may be extremely useful. Many advisers steered their clients away from Bernie Madoff’s fraudulent funds. Investors also need to be made aware of the benefits of diversification and of the effect on their portfolios of tax rules and regulations. There is also evidence that market valuations revert to the mean over the long term, so pointing out when markets look historically cheap or dear can help.

The problem for the industry is that such advice will not be needed very often, and that limits the potential fees. So instead investors are bombarded with endless research on why stock A is better than stock B, why one currency is bound to outperform another and so on. Clients end up churning their portfolios, even though the costs erode their returns.

Perhaps the financial-advice industry survives because the idea that the future is unknowable is just unsatisfying. Some forecast—any forecast—is therefore comforting. Mr Tetlock suggests that “we believe in experts in the same way that our ancestors believe in oracles; we want to believe in a controllable world and we have a flawed understanding of the laws of chance.”

* “Why Do People Pay for Useless Advice? Implications of Gambler’s and Hot-Hand Fallacies in False-Expert Setting”, by Nattavudh Powdthavee and Yohanes Riyanto, Institute for the Study of Labour, May 2012.

Here we go again

Buttonwood, The Economist

THE pattern is eerily familiar. Investors start the year in a blaze of optimism, hoping that the euro zone has been stabilised and that the American economy is growing strongly. By the late spring, the latest example of euro-zone “make and mend” policies shows signs of fraying and the American recovery is proving less robust than hoped. The same description of events applies to both 2011 and 2012, even if last year’s market correction was also triggered by special factors—the terrible damage resulting from the Japanese earthquake and tsunami, along with the Libyan civil war.

This year’s rally really began in late November, and got much of its impetus from the €1 trillion ($1.3 trillion) in three-year loans made by the European Central Bank to the region’s banking system. But the effect of the ECB’s liquidity package has quickly worn off. The MSCI World stockmarket index had gained 12.6% at one stage this year but has seen that advance cut to 2.7%. In Europe, the Euro Stoxx 50 has fallen by 6% in dollar terms; Spanish shares are off by 21%.

Investors have retreated to the safety of selected government bonds. Since the start of 2012, the yields on British and German ten-year government bonds have fallen to levels that are pretty much unprecedented; French yields are a third of a point lower. American yields have fallen, too, but not by as much. The yields on ten-year Bunds are now almost 40 basis points lower than those on Treasuries.

In the periphery the government of Mario Monti in Italy has been more successful in calming the markets than that of Mariano Rajoy in Spain. At the start of the year Italian ten-year yields were almost 150 basis points higher than those of Spain; now they are around 45 basis points lower (see chart). But both are again moving in the wrong direction.

In many ways, the debt crisis confronts euro-zone leaders with a dilemma similar to that facing governments when the banking sector crumbled in 2007 and 2008. Back then, policymakers were forced to distinguish between those banks that were illiquid and just needed emergency loans, and those that were insolvent and needed injections of capital. For a time the authorities appeared to be clueless about this distinction, causing investor alarm. But the American authorities in particular managed to draw a line under their financial crisis by injecting new capital into the (sometimes unwilling) banks and by showing that those banks could pass fairly rigorous stress tests in May 2009. A vigorous equity rally duly occurred.

In contrast, Europe’s leaders have spent much of the past two years treating Greece as a liquidity problem when it is really insolvent. Some of the country’s debts have been forgiven, but not enough. Of course, Europe’s problems are more deep-seated than America’s, thanks to the principal flaw in the euro’s design: that it is a single currency operating in a continent without fiscal union. Politically, it is very hard to reach quick decisions when 17 governments are involved.

But even those countries that are not in the zone have failed to generate the kind of rapid economic growth that has marked previous recoveries. Corporate profits have held up pretty well in the circumstances, which is one reason why the markets are still well ahead of their 2009 levels. But the corollary of those high profits has been depressed real wages, which have weighed on consumer demand. And companies have so far tended to sit on their cash, rather than invest in new plant and equipment or hire new workers.

All this has left the markets desperately waiting for a new “hit” from their central banks, in the form of quantitative easing or additional liquidity support. Each central-bank statement is closely analysed for signs of change, rather as Kremlinologists used to study Politburo photographs for hints of leadership reshuffles.

Like the adrenalin injected into an overdosing Uma Thurman’s heart in “Pulp Fiction”, these central-bank boosts usually provoke an immediate market reaction. But a repeated regime of heroin and adrenalin injections hardly makes for a healthy lifestyle. While it lasts central-bank action means that equity markets are unlikely to crash, since the yields on cash and bonds are so low. At a conference this week organised by Morningstar, a research firm, one fund manager pointed out that Royal Dutch Shell shares yield 4.8%, whereas its bonds pay just 1.5%. But the prospect of markets standing on their own two feet—of surviving without the crutch of massive monetary easing—looks as far away as ever.

Voters versus creditors

Buttonwood, The Economist

ANGELA MERKEL, the German chancellor, spoke for many Europeans when she said last year that “We must re-establish the primacy of politics over the markets.” The Europeans created the euro to prevent the crises caused by currency speculators, only to find themselves pushed around by bond investors.

Politicians have often cursed the markets. Harold Wilson, a British prime minister, used to fulminate against the “gnomes of Zurich” who speculated against the pound. In the mythology of the British Labour Party, a “bankers’ ramp” pushed the party out of office in 1931. James Carville, a political adviser to Bill Clinton, wanted to be reincarnated as the bond market so he could “intimidate everybody”.

In theory, there is an easy answer. If you don’t want to be bothered about the bond markets, don’t borrow from them. The finance ministers of Norway and Saudi Arabia have no cause to worry about their borrowing costs because they are net creditors.

Not all nations can be creditors, of course. But John Maynard Keynes’s plans for the post-1945 monetary system were aimed at limiting the imbalances that arose in the interwar system, and have popped up again in the past 20 years. Since this involved restricting the rights of surplus nations, his plans were circumscribed by Washington, a nice irony now that America is a debtor nation.

After the Bretton Woods system collapsed in 1971, trade imbalances ceased to be much of a constraint on the developed world. Financial markets seemed happy to provide the money to allow countries to run deficits on both the fiscal and trade accounts. This may have led to a fatal complacency on the part of governments, which assumed that their credit was limitless. But rather like Northern Rock, the British bank that became too dependent on the wholesale markets for funding and collapsed in 2007, countries such as Greece and Italy have discovered that investors can suddenly withdraw their favours.

Is the latest run the action of speculators, as Silvio Berlusconi mused in his farewell statement? On the contrary, the sell-off is probably down to caution. The Greek debt deal required private-sector investors to take a 50% hit, while official investors would be repaid in full. This made private-sector investors worry about potential losses elsewhere. They have shifted their assets into the perceived safety of Germany and Britain. In addition, it seems that banks are selling off bonds in an attempt to shrink their balance-sheets and meet new rules designed to make them safer.

Countries can escape from the tyranny of the markets by turning to official lenders: other countries, the International Monetary Fund or the European Financial Stability Facility. But such creditors are just as keen on extracting their pound of flesh (in terms of economic reform) as the private sector.

Vague plans for a fiscal union seem to depend on a bargain in which Germany agrees to transfer money to debtor countries but the debtors agree to limits on their ability to run a deficit. This implies that someone in Brussels (or Frankfurt) will have a veto over a debtor country’s budget.

In short, having lost their ability to control their monetary policy, voters may have to lose control over their fiscal policies as well. National politics will be reduced to dealing with social issues, such as smoking bans.

Perhaps this is inevitable. Just as voters cannot repeal the laws of gravity, they cannot insist that foreign creditors lend them money. Domestic wealth, alternatively, can be taxed or confiscated, although this is a strategy that is likely to be successful only in the short term or during national emergencies such as the second world war. Capital controls worked under the Bretton Woods system but it is not clear whether they can be enforced in an age where money can be transferred through the click of a mouse.

The prospect of financial ruin was one reason why many people feared the introduction of democracy. “The ignorant majority, when unrestrained by a superior class, always sought to tamper with sound money,” said Thomas Hutchinson, a lieutenant governor of Massachusetts in 1753. Alexander Hamilton described the progressive accumulation of debt as “perhaps the natural disease of all governments.” Over the centuries, countries have tried various rules—the gold standard, balanced-budget requirements, independent central banks—in an attempt to limit government profligacy. But when those rules fail, the markets assert their own grim discipline.

Buttonwood: All in the same boat

The Economist

DIVERSIFICATION is supposed to be one of the rare free lunches in finance. Spread your assets geographically (or by asset class) and the chances are that your investments will not rise and fall together. Investors should be able to get the same reward with less risk.

But, as the chart shows, global stockmarkets have steadily become more correlated over the past few decades. Wake to the financial headlines on any given morning and you will find that a sell-off in Asia has spread to Europe and that, all too often, both continents are reacting to a late plunge on Wall Street. It is rare for individual markets to go against the trend.

As a consequence, the fundamentals of individual economies can be less important to their short-term equity performance than investors might expect. Emerging markets have better growth prospects and sounder public finances than their developed-world counterparts. But those Western investors who have sought to take advantage of these differences can end up feeling disappointed. At the end of August, the MSCI emerging-markets index was down by 10.3% in dollar terms since the start of the year. The developed-world index was down by 5.4% over the same period.

Globalisation is partly to blame. The volume of world trade has risen in every year bar one (2009) over the past decade and now represents 29.7% of GDP, up from 23.8% in 2001. Many developed countries are counting on a surge in exports to boost their own sluggish domestic economies.

It is not just a question of trade. Many of the world’s leading companies are multinationals with operations scattered throughout the world. The recent poor growth record of the developed world means that many Western firms are pinning their expansion hopes on Asia or Latin America. By the same token emerging-market exporters like Samsung or Petrobras need consumers in Europe and America to keep spending. Analysis by BNP Paribas finds, for example, that more than 20% of the revenues of constituent companies of the Dow Jones Industrial Average comes from emerging markets; 36% of the revenues of FTSE 100 companies is generated in North America; and almost 14% of the revenues of listed Korean companies stems from Europe.

The Federal Reserve may also be playing its part. Investors have been relying on the Fed not just to revive the American economy but to prop up asset markets through its bouts of quantitative easing (QE). Since the dollar is still the global reserve currency, Fed decisions affect investors all round the world. When Ben Bernanke hinted at a second round of QE in August 2011, the resulting rally was global, not just confined to Wall Street. Fund managers around the world are hoping he opts for a third round.

Another crucial factor may be the existence of large fund-management firms, whose portfolios are diversified across the globe. A new academic paper* looks at how these funds may act to transmit shocks from one market to another.

Fund managers do not make their buy-and-sell decisions based on the economic fundamentals alone. They have to adjust their portfolios as clients send them more money or ask to redeem their holdings. If retail investors in Iowa want their money back, fund managers have to sell something and that may mean Brazilian or Chinese equities.

Those Iowans may well be reacting to domestic news, such as the debt-ceiling crisis in late July or Standard & Poor’s downgrade of America’s credit rating. But the result of their actions is that global markets fall in unison. The authors describe the process in this way: “Global funds substantially alter portfolio allocations in emerging markets in response to funding shocks from their investor base.” They found that those emerging markets that were most exposed to these global funds were both more correlated with one another, and more correlated with the developed markets in which the funds are domiciled.

There is an irony at work here. Global funds are invested in Brazil and China because investors want a diversified portfolio. But the very act of diversification means that these markets become more tied to the developed world and the rewards of diversification are accordingly reduced. It is not really diversification when everyone has the same idea.

* “Asset Fire Sales and Purchases and the International Transmission of Funding Shocks”, by Chotibhak Jotikasthira and Christian Lundblad of the University of North Carolina, and Tarun Ramadorai of the Said Business School in Oxford, August 2011

Buttonwood: The lowdown

The Economist

BOND-MARKET vigilantes have a ferocious reputation but it turns out they can be very forgiving. Although Standard & Poor’s has downgraded America’s credit rating and the 2011 budget deficit is expected to be 9% of GDP, the Treasury can still borrow at a remarkably cheap rate. On August 31st all Treasury bonds maturing within five years were yielding less than 1%.

Short-term bond yields are driven by expectations about the outlook for official interest rates. The Federal Reserve has committed itself to keeping rates at their current ultra-low level (between zero and 0.25%) for the next two years. In turn, such low rates also drag down bond yields at longer maturities.

It all looks very Japanese. As the chart shows, since 1999 ten-year Treasury-bond yields have followed a remarkably similar path to that taken by Japanese bond yields after that country’s economic bubble burst in 1990. The big question is whether they will now stabilise, as Japanese yields did, in the 1-2% range.

Much will depend on the outlook for inflation. Japan had a brief period of deflation in the mid-1990s, followed by a more consistent pattern of flattish prices over the past decade. Real yields have thus been positive for much of the period.

In contrast, the brief burst of American deflation in 2009 was followed by a strong rebound in prices. Headline inflation is running at 3.6%, making real yields markedly negative. (The same is true for real yields on inflation-linked bonds.) That makes bonds look a pretty unattractive option unless investors believe deflation is on its way.

According to the Barclays US bond index, the last time that nominal yields were around today’s level was in 1949 and 1950. Investors who bought bonds back then saw the real value of their holdings halved by the late 1960s. But strategists at Société Générale estimate that the fair value for ten-year Treasury bonds (based on growth and inflation rates over the previous ten years) is just 2.75%, not a long way above current levels. Bonds looked far more overvalued, on this model, in 2002 and 2008.

The bond market is a rather better forecaster of recessions than the average economist. There has been a sharp fall in bond yields even though the Fed’s programme of quantitative easing (creating money to buy bonds) stopped at the end of June, taking a large source of demand out of the market. That is a clear sign that investors are worried about economic growth.

It is true that one big recessionary signal has not appeared—the inversion of the yield curve (meaning that long-term yields fall below short-term rates). But it is impossible to generate such a signal at the moment thanks to the Fed’s policy of near-zero short rates. And that policy is itself a sign that the central bank is extremely concerned about the economic outlook.

Once the debt crisis broke in 2007, it was clear there were four ways that the mess could develop. The best hope was for economies to grow their way out of the problem. But the recovery has been so anaemic that output in the world’s largest developed economies is still below its 2008 levels.

The second route was to inflate the debt away. Headline inflation rates have risen thanks to commodity prices. But there has been no sign yet that the authorities are able to generate a 1970s-style wage-price spiral, even assuming that they want to. There may be some scope for “financial repression”, whereby investors are channelled towards government bonds and real yields are held at negative rates for an extended period, but this is a very slow way of reducing debt.

The third path was outright default. That may be on the cards for Greece but, barring political miscalculation, the chances of it are remote for countries, like America and Britain, which can issue debt in their own currencies.

The fourth possibility was stagnation, which takes us back to the Japanese example. Plenty of investors and commentators have lost money (or face) during the past decade by predicting that Japanese bond yields would rise sharply. But even though Japan’s debt-to-GDP ratio is far higher than those of America and much of Europe, there is no sign yet of imminent collapse.

Japanese investors have proved happy to hold bonds, given that the alternatives have been the country’s moribund equity and property markets. Its example shows why low bond yields are not good news at all for equity and property markets in America and Europe. Instead they are a dreadful omen.

Buttonwood: Forty years on

The Economist

FORGET Watergate. For economic historians, Richard Nixon’s place in history is secure. He was the president who, 40 years ago, severed the link between global currencies and gold and ended the fixed-exchange-rate system.

Under the Bretton Woods regime, world currencies were pegged to the dollar, which in turn was tied to a set price of gold. Central banks had the right to convert their dollar holdings into bullion. But on August 15th 1971 Nixon, in the face of economic difficulties, closed the gold window, devalued the dollar against bullion and imposed a 10% surcharge on imports. The era of paper money and floating exchange rates had arrived.

However, currency crises didn’t go away. In part, that was because the move to floating rates was not complete. The Europeans did not like leaving their currencies to the whims of the markets and made several efforts to limit exchange-rate flexibility within the EU, culminating in the adoption of the euro. The eventual effect was to move financial volatility from the currency to the bond markets, with uncompetitive countries facing higher borrowing costs rather than pressure on their exchange-rate pegs.

The inflexibility of currency pegs has long been cited as a reason for having floating rates. Milton Friedman, a monetarist economist, argued that adjustments were easier in a floating-rate system. In his book, “Essays in Positive Economics”, published in 1953, he wrote that: “It is far simpler to allow one price to change, namely the price of foreign exchange, than to rely upon changes in the multitude of prices that together constitute the internal price structure.”

The Bretton Woods founders had believed that floating rates would be dangerously unstable. But Friedman argued that, provided sensible policies were followed, speculators would act as a stabilising force, preventing currencies from departing too far from fair value.

In fact, exchange rates have been more volatile than Friedman might have expected. The chart shows the dollar versus the yen; although the overall trend has been one of dollar decline, there have been some sharp swings along the way. Despite a notional commitment to floating rates, there have been several bouts of intervention; the latest came on August 4th, when the Japanese tried to drive down their currency. The impact was spoiled when Standard & Poor’s cut America’s credit rating, sending the dollar back down.

The move to floating rates has also had some interesting side-effects. The Bretton Woods system had strict capital controls, designed to protect the exchange-rate pegs. But these became unnecessary in an era of floating rates. As they were abandoned in the early 1980s, capital started flowing round the world at an ever faster rate, with the finance sector taking a cut at every stage. It is surely no coincidence that the rise in the relative wages of financial professionals began at that point.

In addition, the central banks of free-floating currencies no longer had to raise interest rates to defend their exchange rates. Indeed, markets were more tolerant of countries with trade deficits than they were under Bretton Woods. Without the trade constraint, the way was made clear for “the Greenspan put”: the use of interest-rate cuts to rescue financial markets, in effect underwriting asset prices.

By contrast, there were no asset bubbles to speak of in the Bretton Woods era and (not coincidentally) scarcely any financial crises. Between 1945 and 1971, the worst calendar-year loss suffered on Wall Street was a 14.1% decline in 1957.

Perhaps the lesson of the past 40 years is that neither a fixed nor a floating-rate system is a panacea. Many governments have used currency pegs as a shortcut towards economic credibility without the structural reforms needed to ensure their economies remained competitive. Floating rates create the temptation for governments to drive down their currencies and grab a bigger share of world trade. That temptation is very strong at the moment and could lead to further political tensions if America opts for another round of quantitative easing. In a world of competing devaluations, gold keeps driving higher. It surged above $1,800 an ounce on August 11th. In terms of the old gold measure, the dollar has devalued by 98% since the end of the Bretton Woods era.