Riding the waves

By Simon Murray

Family offices that pay for professional investment advice should expect to be kept well informed about trends in economic growth, inflation, interest rates, and currency volatility. This information is crucial for strategic asset allocation and investing across countries, sectors and stocks.

It also pays to be sceptical about economists. They’ve consistently failed to predict when investment bubbles will burst. Their simple indicators don’t capture the complexity of what is going on. For example, we are witnessing both inflationary and deflationary pressures at the moment. Their recommended solutions are not working.

Neo-Keynesian economists want to burden the public with more debt, yet don’t know how to create sustainable economic growth. But the alternative, mass austerity, is unpalatable.

The reality is that there is not one economy in the modern world, but three: the real economy, the shadow banking economy and the political economy. Family offices’ investment and risk assessments need to follow events in these economies very closely, and devise a strategy for riding the waves that are coming our way.

Real economies around the world have boom and bust cycles. It’s an inevitable consequence of changing patterns of demand, supply and competition, as well as factors outside most people’s control, such as natural disasters, resource shortages/ discoveries, and war and peace.

People make fortunes in the real economy, even in economic depressions. Every day, enterprising individuals set up new businesses, taking creative leaps into new markets or delivering valuable improvements in existing markets.

Investing in people who have the vision, determination and luck to succeed in business is one of the most exciting and rewarding parts of running a family office. Family offices, with a rich entrepreneurial heritage, work hard to stay ahead of the pack. They spot opportunities and trends before other people, invest, ride the waves and get off quickly if necessary.

The second economy is the shadow banking economy. The world of leveraged finance and speculation, derivatives, hedging, shorting and hostile M&A activity. Generating paper wealth from people’s tangible assets. Since 1990, this economy has grown enormously, driven by global capital markets, new technologies and new financial instruments.

The third economy is the political economy. Some politicians thought they could end boom and bust. When the real economy slowed, they could leverage the shadow economy to provide new growth. More insidiously, when real economic growth failed to cover the burgeoning costs of the state, the shadow economy could re-finance these costs “off-balance sheet”; writing obligations to be paid by future generations.

Unfortunately, they didn’t think through the consequences of unfettered leverage, or collateral damage from events like the Lehman’s collapse. Not only is the economy at risk, but society itself. Politicians can live with debt, but they rightly fear a run on the banks, when the public can’t take “my cash out of my account”. If the banking system fails, things could get very nasty. Bad PR from bailing out banks (something that is still, subtly, going on) and bonuses is the price politicians pay.

We’ve probably reached a point where – other things being equal – real economies, for all their spirit and endeavour, will never be able to grow fast enough to repay the debts and obligations created by the shadow economy. The key phrase here is “other things being equal”. It will be interesting to see how world leaders try to engineer a soft landing rather than a crash.

While this plays out, banking fortunes are still being made and lost. One lesson from Lehmans has been: follow the US Federal Reserve and other central banks. Where are they pumping in the money? What are their real intentions? What are the unintended consequences? How will asset prices, detached from economic fundamentals, perform?

But following the Federal Reserve might ultimately be an unwise strategy. They are creating new paper bubbles in the shadow economy. Like King Canute, central bankers cannot control crashing waves. Family offices must focus on predicting the warning signals of these future crashes.

It is no surprise to see the popularity of investment in tangible assets with strong defensive qualities: farm land, precious metals, companies in recession-proof sectors with strong cash fl ows, and so on. Many political leaders are like medieval monarchs. They’ll continue to spend, tax, and borrow, wisely and unwisely, until the people say “enough is enough”. And that’s when a new wave begins.

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