Investment trends – part one

Ignacio de la Torre. Professor. IE Business School

16 May 2012

Behavioral finance has a marked short-term impact on markets, but the price of assets will always depend more on efficiency levels in the long run.

Which is the riskier country in which to invest, Argentina or Spain? I will be explaining the answer to this question, in true soap opera style, at the end of the second column of this series of articles. Said answer will include the currently highly relevant considerations about the eventual validity of the hypothesis of market efficiency and the growing influence of behavioral finance, which serves to demonstrate how the prices of assets are the result of human decisions, which in turn are based on human emotions, thereby proving that psychological factors play an important role in determining the price of assets. If you look at graphs that illustrate the number of searches on Google for both these terms you will see that they are converging.

The message is clear. behavioural finance is on the rise. My opinion is that if I have learnt anything from years of observing the market, it is that behavioral finance has a markedly short-term effect on markets, and that efficiency is what determines prices in the long run. By way of example, if I had asked “Which is the riskier country in which to invest, Spain or Egypt?”, the answer would not be that much different, but there would probably be more debate, and the answer would depend on which school of thought you adhere to.

Given that in these heroic times we are fully immersed in the ebbs and flows of behavioural finance and the short-term impact they have, I am going to devote this article to talking about the most basic trends that they will exhibit in the medium term.

First, an asset is only an asset if it is capable of generating future cash flow (which is why many banks’ “assets” are not assets at all). The base price of an asset is the cost of capital (from which the future cash flows that an asset generates are deducted) and the this depends primarily on the real interest rate (excluding inflation). The real rate of interest is the result of levels of supply and demand worldwide for savings and investment. Generally speaking, in times of economic difficulty people tend to save more, and in times of growth, they tend to invest more (and therefore save less). Moreover, the structural policies of large emerging countries, particularly China, consist of changing the production model from mercantilist (growth based on exterior markets, the accumulation of reserves through trade surplus with artificially controlled rates of exchange) to one that places greater emphasis on domestic consumption. Hence both factors, which are gradual but constant, will increase the real interest rate.

Second, future cash flow will have to be adjusted taking into account future inflation. In order to do this you have to gauge how high this might reach and also how reliable such a prediction is. As we have written in the past, interest rates of practically zero, extraordinarily lax central banks, (between 20% and 30% of record level GNP) and expansive fiscal policies in the EU mean that inflation will be by far the main threat facing savers. Inflation is, in practice, an “elegant” form of default, and was the method employed to deflate debt after the Second World War, and current levels of indebtedness are at similar levels.

Although no central banker will openly admit to tolerating inflation, unofficially they do, because they know it is the lesser of two evils. That’s why the objective of the ECB is to get the inflation rate down to 2%, yet although it currently stands at 2.6% interest rates are still low, it has just injected a billion Euros into the system. In the short term inflation is no great threat, because general unease reduces the speed of money flows and therefore fewer transactions, lower demand and less inflationist pressure. Meanwhile, excess capacity vis a vis demand (output gap) also reduces this risk. In the medium term the risk mentality is neutralized, increasing the velocity of money, and the output gap will disappear as a result of growing demand and years of infra investment. The result will be higher levels of inflation that will be a bone of contention of financial repression: the transfer of wealth from the saver to the debtor.

Third, the world is growing at a slower pace than in recent years, purging past excesses, but current levels of risk (current account imbalances) are much less worrying than in 2007. On a national scale, a current account deficit implies over consumption or investment in proportion to local savings levels. The difference is financed by foreign savers, who in their countries are saving more than they are consuming or investing. This current account deficit implies that the debt will have to be repaid using future revenues, which means that these revenues will not result in consumption or investment when they happen, but rather in a higher level of saving in order to serve the previously generated debt.

This circuit works until the foreign savers stops funding the deficit. That is when consumption and investment have to be reduced to adapt them to local savings, and that could cause a recession. This is why countries that grew too fast fuelled by debt have suffered horrendous recessions, but now they have almost symbolic deficits (Spain could actually have a surplus before the end of 2013, and the US has a far lower deficit than before the crisis started, and a more sustainable one given that it is home to the world reserve currency). Meanwhile the surplus of many emerging countries is evaporating bit by bit. Thus we have the paradox that it is the savings of the poor that has financed consumption by the rich between 2000 and 2007.

In 1289 King Philip IV of France issued false coins in an effort to counteract royal revenues that were lower than royal spending levels. The result was galloping inflation, which made the vast majority of France’s lower classes suffer. But in addition to increasing prices it also made royal creditors, namely upper-class clergy and nobles, very angry, because the original loan made to the royal coffers using good coins had plummeted in value as a result of inflation. Hence they gave the monarch an ultimatum: sort out the monetary problem or lose the basis of your power.

We will see how it all ended in the next article in this series…


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