Financialization refers to the increasing influence and dominance of financial markets, institutions, and activities in the economy. It involves the growing importance of financial transactions, speculation, and the pursuit of short-term profits in shaping economic decisions. While financialization has become a prominent feature of modern economies, it is considered a fallacy because it prioritizes financial activities over real productive activities, leading to detrimental effects on the economy and society. Let's explore this concept further with simple examples, quotes, and explanations:
Focus on short-term gains: Financialization often emphasizes short-term profits and quick returns on investments, rather than long-term productive investments. Economist John Maynard Keynes warned, "Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation." This suggests that when financial activities overshadow productive investments, it can lead to economic instability and hinder sustainable growth.
Financial sector dominance: Financialization can lead to an over-reliance on the financial sector for economic growth, potentially at the expense of other sectors. Economist Hyman Minsky cautioned, "In capitalist economies, the financial system is supposed to serve the needs of the real economy, not the other way around." However, when financial activities take precedence, it can create an imbalance, diverting resources away from productive sectors like manufacturing, innovation, and infrastructure development.
Risk and instability: Financialization often involves increased complexity and risk-taking in financial markets. Financial instruments and practices become convoluted, making it difficult to assess true risks. Nobel laureate economist Robert Shiller observed, "Financial innovation is a little like technology innovation: not all of it has value." The pursuit of financial innovation without proper regulation and oversight can lead to financial crises, as seen in the 2008 global financial crisis, when risky financial practices caused severe economic downturns.
Growing inequality: Financialization tends to exacerbate wealth and income inequality. Financial activities can disproportionately benefit a small segment of society, such as high-income individuals, large corporations, and financial institutions. Economist Thomas Piketty noted, "When the rate of return on capital exceeds the rate of growth of output and income, as it did in the 19th century and seems quite likely to do again in the 21st, capitalism generates arbitrary and unsustainable inequalities." The concentration of wealth in the financial sector can widen the wealth gap and hinder social mobility.
Neglect of real economy: Financialization can divert resources and attention away from the real economy, where goods and services are produced. Financial markets can become detached from the underlying value and productivity of the real economy. Economist Ha-Joon Chang remarked, "Financial markets, far from being simply 'efficient' mechanisms for allocating capital, are inherently unstable and crisis-prone." Neglecting the real economy in favor of speculative financial activities can lead to economic imbalances and distortions.
In conclusion, financialization as a fallacy arises when financial activities and priorities overshadow real productive activities and the long-term health of the economy. The focus on short-term gains, dominance of the financial sector, increased risk and instability, growing inequality, and neglect of the real economy are all detrimental consequences of financialization. Recognizing and addressing these issues is crucial to ensuring a more balanced and sustainable economic system that benefits society as a whole.
Russia’s invasion of Ukraine has led to a sharp rise in defence spending writes John Paul Rathbone in the FT
Next April, for the first time in more than three centuries, Danes will have to work on the holiday of Great Prayer after the government scrapped the religious day off partly to pay for extra defence spending.
The decision, approved in March, was deeply unpopular: in one poll, 70 per cent of Danes opposed it. But economists have praised Copenhagen for enacting a plan to meet its rising defence bills, unlike many other governments.
“Nobody wants to pay more taxes. But at the same time, everybody wants better defence and good health services too,” John Llewellyn, a former head of economic forecasting at the OECD, said. “At some point the issue will be forced into the public arena, as nobody is clear how the funds will be raised.”
Japan, worried by China’s rise and the risk of war in the Indo-Pacific, has not specified how it will fund a planned two-thirds increase in its defence budget by 2027. The UK, spurred by Russia’s war on Ukraine, wants to eventually boost military spending to 2.5 per cent of gross domestic product but only as “fiscal and economic circumstances allow”.
Germans, unnerved by Russian aggression, want to increase defence spending, but not if it means losing a public holiday. France has not detailed how it will pay for a planned 40 per cent rise in its military budget over the next five years. The same is true for Poland, which aims to almost double its spending to 4 per cent of GDP.
How to pay for wars is an issue as old as war itself. Cicero, the Roman statesman, said the “sinews of war are infinite money”. In 1694, the Bank of England was founded to help William III finance war with France. Today, even as the world appears increasingly chaotic, spending looks more finite amid an environment of rising interest rates and high government debt burdens.
Europe is in the middle of its biggest armed conflict since 1945. Geopolitical tensions between China and Taiwan are on the rise. Iran may soon be able to make a nuclear weapon. In addition, global challenges such as climate change and migration may also force governments to spend big.
The Stockholm International Peace Research Institute (Sipri) calculates that global defence spending rose by 4 per cent to reach a record $2.24tn last year. This year, it is set to continue rising, even as higher rates increase governments’ borrowing costs.
Economists such as Lawrence Summers, former US Treasury secretary, and Olivier Blanchard, former chief economist at the IMF, have suggested higher defence spending could even contribute to driving interest rates higher.
“One scenario is that countries which already increased defence spending in 2022 continue to do so, while those that have said they will begin to increase defence spending in 2023 actually start,” said Diego Lopes Da Silva, senior researcher at Sipri’s military expenditure and arms production programme.
Among the world’s five biggest defence spenders, the numbers are mind-boggling.
In the US, politicians carved out an exemption in the debt ceiling talks to allow for a 3 per cent rise in military spending to $886bn in 2024. China’s defence budget, which Sipri estimates to be $292bn, is on track this year for its 29th consecutive annual increase.
Russia, which spent an estimated $86bn on defence last year, has meanwhile said there will be “no funding restrictions” for its war against Ukraine, even as its budget remains classified. India plans to increase its defence budget by 13 per cent this coming year to $73bn, while Saudi Arabia, fearful of a nuclear Iran, now spends 7.5 per cent of GDP on defence, second only to Ukraine.
In Nato, only seven of its 31 members last year met the alliance’s self imposed defence spending target of 2 per cent of GDP. If they all did, total outlays would rise by over $150bn a year, FT research shows.
While war was one of “the most expensive and least productive of human activities”, James Grant, a financial historian and editor of the Grant’s Interest Rate Observer, noted that there was “also a tendency for peace to explode periodically in our faces.”
Grant added: “When that happens, there is often a confluence of promises to pay and money printing.”
As a general rule, “short, hot wars” that require a sudden surge in spending are financed by extra borrowing, while “long, cold wars” that require sustained defence spending are financed by taxes.
The Napoleonic and first and second world wars were largely financed by debt. By contrast, during the long decades of the cold war, the west financed its defence spending through higher taxation. In the quarter century that preceded the fall of the Berlin Wall, tax revenues among OECD countries rose on average to more than 32 per cent of GDP from 25 per cent, while debt levels generally fell.
“For short wars, governments can finance the expenditure by borrowing,” said James Macdonald, author of A Free Nation Deep in Debt, a history of public finance and wars. “But if there is a long war, the more it goes on, the more you have to use other methods, such as taxes.”
Wars are also often accompanied by higher inflation and the suppression of interest rates. During the second world war, US wholesale prices rose by an average of 8.2 per cent a year, even as interest rates on long-term debt were fixed at 2.5 per cent — a gap that helped Washington inflate away the value of the bonds the US issued.
“All wars are generally associated with some inflation. Politicians don’t like to put up taxes [to pay for wars], and inflation is a hidden tax,” said Richard Sylla, co-author of A History of Interest Rates.
Economists suspect rebuilding long-term defence spending, which has dropped by a third across OECD countries since the fall of the Berlin Wall, would require a mix of higher taxes and spending cuts elsewhere.
“The politics can’t be avoided,” said Llewellyn. “Societies face a series of conundrums and some difficult choices have to be made.”
Five weeks after the collapse of Silicon Valley Bank, there is no consensus on whether the ensuing financial stress in North America and Europe has run its course or is a foretaste of worse to come.
Equally pressing is the question of whether, against the backdrop of still high inflation, central banks in advanced economies will soon row back from monetary tightening and pivot towards easing.
These questions, which are of overwhelming importance for investors, savers and mortgage borrowers, are closely related. For if banks and other financial institutions face liquidity crises when inflation is substantially above the central banks’ target, usually of about 2 per cent, acute tension arises between their twin objectives of price stability and financial stability. In the case of the US Federal Reserve, the price stability objective also conflicts with the goal of maximum employment.
The choices made by central banks will have a far-reaching impact on our personal finances. If inflation stays higher for longer, there will be further pain for those who have invested in supposedly safe bonds for their retirement. If the central banks fail to engineer a soft landing for the economy, investors in risk assets such as equities will be on the rack. And for homeowners looking to refinance their loans over the coming months, any further tightening by the Bank of England will feed into mortgage costs.
The bubble bursts
SVB, the 16th largest bank in the US, perfectly illustrates how the central banks’ inflation and financial stability objectives are potentially in conflict. It had been deluged with mainly uninsured deposits — deposits above the official $250,000 insurance ceiling — that far exceeded lending opportunities in its tech industry stamping ground. So it invested the money in medium and long-dated Treasury and agency securities. It did so without hedging against interest rate risk in what was the greatest bond market bubble in history.
The very sharp rise in policy rates over the past year pricked the bubble, so depressing the value of long-dated bonds. This would not have been a problem if depositors retained confidence in the bank so that it could hold the securities to maturity. Yet, in practice, rich but nervous uninsured depositors worried that SVB was potentially insolvent if the securities were marked to market.
An inept speech by chief executive Greg Becker on March 9 quickly spread across the internet, causing a quarter of the bank’s deposit base to flee in less than a day and pushing SVB into forced sales of bonds at huge losses. The collapse of confidence soon extended to Signature Bank in New York, which was overextended in property and increasingly involved in crypto assets. Some 90 per cent of its deposits were uninsured, compared with 88 per cent at SVB.
Fear spread to Europe, where failures of risk management and a series of scandals at Credit Suisse caused deposits to ebb away. The Swiss authorities quickly brokered a takeover by arch rival UBS, while in the UK the Bank of England secured a takeover of SVB’s troubled UK subsidiary by HSBC for £1.
These banks do not appear to constitute a homogeneous group. Yet, in their different ways, they demonstrate how the long period of super-low interest rates since the great financial crisis of 2007-09 introduced fragilities into the financial system while creating asset bubbles. As Jon Danielsson and Charles Goodhart of the London School of Economics point out, the longer monetary policy stayed lax, the more systemic risk increased, along with a growing dependence on money creation and low rates.
The ultimate consequence was to undermine financial stability. Putting that right would require an increase in the capital base of the banking system. Yet, as Danielsson and Goodhart indicate, increasing capital requirements when the economy is doing poorly, as it is now, is conducive to recession because it reduces banks’ lending capacity. So we are back to the policy tensions outlined earlier.
Part of the problem of such protracted lax policy was that it bred complacency. Many banks that are now struggling with rising interest rates had assumed, like SVB, that interest rates would remain low indefinitely and that central banks would always come to the rescue. The Federal Deposit Insurance Corporation estimates that US banks’ unrealised losses on securities were $620bn at the end of 2022.
A more direct consequence, noted by academics Raghuram Rajan and Viral Acharya, respectively former governor and deputy governor of the Reserve Bank of India, is that the central banks’ quantitative easing since the financial crisis, whereby they bought securities in bulk from the markets, drove an expansion of banks’ balance sheets and stuffed them with flighty uninsured deposits.
Rajan and Acharya add that supervisors in the US did not subject all banks to the same level of scrutiny and stress testing that they applied to the largest institutions. So these differential standards may have caused a migration of risky commercial real estate loans from larger, better-capitalised banks to weakly capitalised small and midsized banks. There are grounds for thinking that this may be less of an issue in the UK, as we shall see.
A further vulnerability in the system relates to the grotesque misallocation of capital arising not only from the bubble-creating propensity of lax monetary policy but from ultra-low interest rates keeping unprofitable “zombie” companies alive. The extra production capacity that this kept in place exerted downward pressure on prices.
Today’s tighter policy, the most draconian tightening in four decades in the advanced economies with the notable exception of Japan, will wipe out much of the zombie population, thereby restricting supply and adding to inflationary impetus. Note that the total number of company insolvencies registered in the UK in 2022 was the highest since 2009 and 57 per cent higher than 2021.
A system under strain
In effect, the shift from quantitative easing to quantitative tightening and sharply increased interest rates has imposed a gigantic stress test on both the financial system and the wider economy. What makes the test especially stressful is the huge increase in debt that was encouraged by years of easy money.
William White, former chief economist at the Bank for International Settlements and one of the few premier league economists to foresee the great financial crisis, says ultra easy money “encouraged people to take out debt to do dumb things”. The result is that the combined debt of households, companies and governments in relation to gross domestic product has risen to levels never before seen in peacetime.
All this suggests a huge increase in the scope for accidents in the financial system. And while the upsets of the past few weeks have raised serious questions about the effectiveness of bank regulation and supervision, there is one respect in which the regulatory response to the great financial crisis has been highly effective. It has caused much traditional banking activity to migrate to the non-bank financial sector, including hedge funds, money market funds, pensions funds and other institutions that are much less transparent than the regulated banking sector and thus capable of springing nasty systemic surprises.
An illustration of this came in the UK last September following the announcement by Liz Truss’s government of unfunded tax cuts in its “mini” Budget. It sparked a rapid and unprecedented increase in long-dated gilt yields and a consequent fall in prices. This exposed vulnerabilities in liability-driven investment funds in which many pension funds had invested in order to hedge interest rate risk and inflation risk.
Such LDI funds invested in assets, mainly gilts and derivatives, that generated cash flows that were timed to match the incidence of pension outgoings. Much of the activity was fuelled by borrowing.
UK defined-benefit pension funds, where pensions are related to final or career average pay, have a near-uniform commitment to liability matching. This led to overconcentration at the long end of both the fixed-interest and index-linked gilt market, thereby exacerbating the severe repricing in gilts after the announcement. There followed a savage spiral of collateral calls and forced gilt sales that destabilised a market at the core of the British financial system, posing a devastating risk to financial stability and the retirement savings of millions.
This was not entirely unforeseen by the regulators, who had run stress tests to see whether the LDI funds could secure enough liquidity from their pension fund clients to meet margin calls in difficult circumstances. But they did not allow for such an extreme swing in gilt yields.
Worried that this could lead to an unwarranted tightening of financing conditions and a reduction in the flow of credit to households and businesses, the BoE stepped in to the market with a temporary programme of gilt purchases. The purpose was to give LDI funds time to build their resilience and encourage stronger buffers to cope with future volatility in the gilts market.
The intervention was highly successful in terms of stabilising the market. Yet, by expanding its balance sheet when it was committed to balance sheet shrinkage in the interest of normalising interest rates and curbing inflation, the BoE planted seeds of doubt in the minds of some market participants. Would financial stability always trump the central bank’s commitment to deliver on price stability? And what further dramatic repricing incidents could prompt dangerous systemic shocks?
Inflation before all?
The most obvious scope for sharp repricing relates to market expectations about inflation. In the short term, inflation is set to fall as global price pressures fall back and supply chain disruption is easing, especially now China continues to reopen after Covid-19 lockdowns. The BoE Monetary Policy Committee’s central projection is for consumer price inflation to fall from 9.7 per cent in the first quarter of 2023 to just under 4 per cent in the fourth quarter.
The support offered by the Fed and other central banks to ailing financial institutions leaves room for a little more policy tightening and the strong possibility that this will pave the way for disinflation and recession. The point was underlined this week by the IMF, which warned that “the chances of a hard landing” for the global economy had risen sharply if high inflation persists.
Yet, in addition to the question mark over central banks’ readiness to prioritise fighting inflation over financial stability, there are longer-run concerns about negative supply shocks that could keep upward pressure on inflation beyond current market expectations, according to White. For a start, Covid-19 and geopolitical friction are forcing companies to restructure supply lines, increasing resilience but reducing efficiency. The supply of workers has been hit by deaths and long Covid.
White expects the production of fossil fuels and metals to suffer from recently low levels of investment, especially given the long lags in bringing new production on stream. He also argues that markets underestimate the inflationary impact of climate change and, most importantly, the global supply of workers is in sharp decline, pushing up wage costs everywhere.
Where does the UK stand in all this? The resilience of the banking sector has been greatly strengthened since the financial crisis of 2007-08, with the loan-to-deposit ratios of big UK banks falling from 120 per cent in 2008 to 75 per cent in the fourth quarter of 2022. Much more of the UK banks’ bond portfolios are marked to market for regulatory and accounting purposes than in the US.
The strength of sterling since the departure of the Truss government means the UK’s longstanding external balance sheet risk — its dependence on what former BoE governor Mark Carney called “the kindness of strangers” — has diminished somewhat. Yet huge uncertainties remain as interest rates look set to take one last upward step.
Risks for borrowers and investors
For mortgage borrowers, the picture is mixed. The BoE’s Financial Policy Committee estimates that half the UK’s 4mn owner-occupier mortgages will be exposed to rate rises in 2023. But, in its latest report in March, the BoE’s FPC says its worries about the affordability of mortgage payments have lessened because of falling energy prices and the better outlook for employment.
The continuing high level of inflation is reducing the real value of mortgage debt. And, if financial stability concerns cause the BoE to stretch out the period over which it brings inflation back to its 2 per cent target, the real burden of debt will be further eroded.
For investors, the possibility — I would say probability — that inflationary pressures are now greater than they have been for decades raises a red flag, at least over the medium and long term, for fixed-rate bonds. And, for private investors, index-linked bonds offer no protection unless held to maturity.
That is a huge assumption given the unknown timing of mortality and the possibility of bills for care in old age that may require investments to be liquidated. Note that the return on index-linked gilts in 2022 was minus 38 per cent, according to consultants LCP. When fixed-rate bond yields rise and prices fall, index-linked yields are pulled up by the same powerful tide.
Of course, in asset allocation there can be no absolute imperatives. It is worth recounting the experience in the 1970s of George Ross Goobey, founder of the so-called “cult of the equity” in the days when most pension funds invested exclusively in gilts.
While running the Imperial Tobacco pension fund after the war he famously sold all the fund’s fixed-interest securities and invested exclusively in equities — with outstanding results. Yet, in 1974, he put a huge bet on “War Loan” when it was yielding 17 per cent and made a killing. If the price is right, even fixed-interest IOUs can be a bargain in a period of rip-roaring inflation.
A final question raised by the banking stresses of recent weeks is whether it is ever worth investing in banks. In a recent FT Money article, Terry Smith, chief executive of Fundsmith and a former top-rated bank analyst, says not. He never invests in anything that requires leverage (or borrowing) to make an adequate return, as is true of banks. The returns in banking are poor, anyway. And, even when a bank is well run, it can be destroyed by a systemic panic.
Smith adds that technology is supplanting traditional banking. And, he asks rhetorically, have you noticed that your local bank branch has become a PizzaExpress, in which role, by the way, it makes more money?
A salutary envoi to the tale of the latest spate of bank failures.
Valentina Pop, Sam Fleming and James Politi in The FT
It was the third day of the war in Ukraine, and on the 13th floor of the European Commission’s headquarters Ursula von der Leyen had hit an obstacle.
The commission president had spent the entire Saturday working the phones in her office in Brussels, seeking consensus among western governments for the most far-reaching and punishing set of financial and economic sanctions ever levelled at an adversary.
With Russia seemingly intent on a rapid occupation of Ukraine, emotions were running high. During a video call with EU leaders on February 24, the day the invasion began, Volodymyr Zelensky, the Ukrainian president, warned: “I might not see you again because I’m next on the list.”
A deal was close but, in Washington, Treasury secretary Janet Yellen was still reviewing the details of the most dramatic and market-sensitive measure — sanctioning the Russian central bank itself. The US had been the driving force behind the sanctions push but, as Yellen pored over the fine print, the Europeans were anxious to push the plans over the finishing line.
Von der Leyen called Mario Draghi, Italian prime minister, and asked him to thrash the details out directly with Yellen. “We were all waiting around, asking, ‘What’s taking so long?’” recalls an EU official. “Then the answer came: Draghi has to work his magic on Yellen.”
Yellen, who used to chair the US Federal Reserve, and Draghi, a former head of the European Central Bank, are veterans of a series of dramatic crises — from the 2008-09 financial collapse to the euro crisis. All the while, they have exuded calm and stability to nervous financial markets.
But in this case, the plan agreed by Yellen and Draghi to freeze a large part of Moscow’s $643bn of foreign currency reserves was something very different: they were effectively declaring financial war on Russia.
The stated intention of the sanctions is to significantly damage the Russian economy. Or as one senior US official put it later that Saturday night after the measures were announced, the sanctions would push the Russian currency “into freefall”.
This is a very new kind of war — the weaponisation of the US dollar and other western currencies to punish their adversaries.
It is an approach to conflict two decades in the making. As voters in the US have tired of military interventions and the so-called “endless wars”, financial warfare has partly filled the gap. In the absence of an obvious military or diplomatic option, sanctions — and increasingly financial sanctions — have become the national security policy of choice.
“This is full-on shock and awe,” says Juan Zarate, a former senior White House official who helped devise the financial sanctions America has developed over the past 20 years. “It’s about as aggressive an unplugging of the Russian financial and commercial system as you can imagine.”
The weaponisation of finance has profound implications for the future of international politics and economics. Many of the basic assumptions about the post cold war era are being turned on their head. Globalisation was once sold as a barrier to conflict, a web of dependencies that would bring former foes ever closer together. Instead, it has become a new battleground.
The potency of financial sanctions derives from the omnipresence of the US dollar. It is the most used currency for trade and financial transactions — with a US bank often involved. America’s capital markets are the deepest in the world, and US Treasury bonds act as a backstop to the global financial system.
As a result, it is very hard for financial institutions, central banks and even many companies to operate if they are cut off from the US dollar and the American financial system. Add in the euro, which is the second most held currency in central bank reserves, as well as sterling, the yen and the Swiss franc, and the impact of such sanctions is even more chilling.
The US has sanctioned central banks before — North Korea, Iran and Venezuela — but they were largely isolated from global commerce. The sanctions on Russia’s central bank are the first time this weapon has been used against a major economy and the first time as part of a war — especially a conflict involving one of the leading nuclear powers.
Of course, there are huge risks in such an approach. The central bank sanctions could prompt a backlash against the dollar’s dominance in global finance. In the five weeks since the measures were first imposed, the Russian rouble has recovered much of the ground it initially lost and officials in Moscow claim they will find ways around the sanctions.
Whatever the result, the moves to freeze Russia’s reserves marks a historic shift in the conduct of foreign policy. “These economic sanctions are a new kind of economic statecraft with the power to inflict damage that rivals military might,” US President Joe Biden said in a speech in Warsaw in late March. The measures were “sapping Russian strength, its ability to replenish its military, and its ability to project power”.
Global financial police
Like so much else in American life, the new era of financial warfare began on 9/11. In the aftermath of the terror attacks, the US invaded Afghanistan, moved on to Iraq to topple Saddam Hussein and used drones to kill alleged terrorists on three continents. But with much less scrutiny and fanfare, it also developed the powers to act as the global financial police.
Within weeks of the attacks on New York and Washington, George W Bush pledged to “starve the terrorists of funding”. The Patriot Act, the controversial law, which provided the basis for the Bush administration’s use of surveillance and indefinite detention, also gave the Treasury department the power to effectively cut off any financial institution involved in money laundering from the US financial system.
By coincidence, the first country to be threatened under this law was Ukraine, which the Treasury warned in 2002 risked having its banks compromised by Russian organised crime. Shortly after, Ukraine passed a new law to prevent money laundering.
Treasury officials also negotiated to gain access to data about suspected terrorists from Swift, the Belgium-based messaging system that is the switchboard for international financial transactions — the first step in an expanded network of intelligence on money moving around the world.
The financial toolkit used to go after al-Qaeda’s money was soon applied to a much bigger target — Iran and its nuclear programme.
Stuart Levey, who had been appointed as the Treasury’s first under-secretary of terrorism and financial intelligence, remembers hearing Bush complain that all the conventional trade sanctions on Iran had already been imposed, leaving the US without leverage. “I pulled my team together and said: ‘We haven’t begun to use these tools, let’s give him something he can use with Iran’,” he says.
The US sought to squeeze Iran’s access to the international financial system. Levey and other officials would visit European banks and quietly inform them about accounts with links to the Iranian regime. European governments hated that an American official was effectively telling their banks how to do business, but no one wanted to fall foul of the US Treasury.
During the Obama administration, when the White House was facing pressure to take military action against its nuclear installations, the US imposed sanctions on Iran’s central bank — the final stage in a campaign to strangle its economy.
Levey argues that financial sanctions not only put pressure on Iran to negotiate the 2015 deal on its nuclear programme but also cleared a path for this year’s action on Russia.
“On Iran, we were using machetes to cut down the path step by step, but now people are able to go down it very quickly,” he says. “Going after the central bank of a country like Russia is about as powerful a step as you can take in the category of financial sector sanctions.”
Central banks do not just print money and monitor the banking system, they can also provide a vital economic buffer in a crisis — defending a currency or paying for essential imports.
Russia’s reserves increased after its 2014 annexation of Crimea as it sought insurance against future US sanctions — earning the term “Fortress Russia”. China’s large holdings of US Treasury bonds were once seen as a potential source of geopolitical leverage. “How do you deal toughly with your banker?” then secretary of state Hillary Clinton asked in 2009.
But the western sanctions on Russia’s central bank have undercut its ability to support the economy. According to Official Monetary and Financial Institutions Forum, a central bank research and advisory group, around two-thirds of Russia’s reserves are likely to have been neutralised.
“The action against the central bank is rather like if you have savings to be used in case of emergency and when the emergency arrives the bank says you can’t take them out,” says a senior European economic policy official.
A revived transatlantic alliance
There is an irony behind a joint package of American and EU financial sanctions: European leaders have spent much of the past five decades criticising the outsized influence of the US currency.
One of the striking features of the war in Ukraine is the way Europe has worked so closely with the US. Sanctions planning began in November when western intelligence picked up strong evidence that Vladimir Putin’s forces were building up along the Ukrainian border.
Biden asked Yellen to draw up plans for what measures could be taken to respond to an invasion. From that moment the US began coordinating with the EU, UK and others. A senior state department official says that between then and the February 24 invasion, top Biden administration officials spent “an average of 10 to 15 hours a week on secure calls or video conferences with the EU and member states” to co-ordinate the sanctions.
In Washington, the sanctions plans were led by Daleep Singh, a former New York Fed official now deputy national security adviser for international economics at the White House, and Wally Adeyemo, a former BlackRock executive serving as deputy Treasury secretary. Both had worked in the Obama administration when the US and Europe had disagreed about how to respond to Russia’s annexation of Crimea.
The EU was also desperate to avoid a more recent embarrassing precedent regarding Belarus sanctions, which ended up much weaker as countries sought carve-outs for their industries. So in a departure from previous practices, the EU effort was co-ordinated directly from von der Leyen’s office through Bjoern Seibert, her chief of staff.
“Seibert was key, he was the only one having the overview on the EU side and in constant contact with the US on this,” recalls an EU diplomat.
A senior state department official says Germany’s decision to scrap the Nord Stream 2 pipeline after the invasion was crucial in bringing hesitant Europeans along. It was “a very important signal to other Europeans that sacred cows would have to be sacrificed,” says the official.
The other central figure was Canada’s finance minister Chrystia Freeland, who is of Ukrainian descent and has been in close contact with officials in Kyiv. Just a few hours after Russian tanks started rolling into Ukraine, Freeland sent a written proposal to both the US Treasury and the state department with a specific plan to punish the Russian central bank, a western official says. That day, Justin Trudeau, Canada’s prime minister, raised the idea at a G7 leaders emergency summit. And Freeland issued an emotional message to the Ukrainian community in Canada. “Now is the time to remember,” she said, before switching to Ukrainian, “Ukraine is not yet dead.”
The threat of economic pain may not have deterred Putin from invading, but western leaders believe the financial sanctions that have been put in place since the invasion are evidence of a revitalised transatlantic alliance — and a rebuke to the idea that democracies are too slow and hesitant.
“We have never had in the history of the European Union such close contacts with the Americans on a security issue as we have now — it’s really unprecedented,” says one senior EU official.
Draghi takes the initiative
In the end, the move against Russia’s central bank was the product of 72 hours of intensive diplomacy that mixed high emotion and technical detail.
The idea had not been the priority of prewar planning, which focused more on which Russian banks to cut off from Swift. But the ferocity of Russia’s invasion brought the most aggressive sanctions options to the fore.
“The horror of Russia’s unacceptable, unjustified, and unlawful invasion of Ukraine and targeting of civilians — that really unlocked our ability to take further steps,” says one senior state department official.
In Europe, it was Draghi who pushed the idea of sanctioning the central bank at the emergency EU summit on the night of the invasion. Italy, a big importer of Russian gas, had often been hesitant in the past about sanctions. But the Italian leader argued that Russia’s stockpile of reserves could be used to cushion the blow of other sanctions, according to one EU official.
“To counter that . . . you need to freeze the assets,” the official says.
The last-minute nature of discussions was critical to ensure Moscow was caught off-guard: given enough notice, Moscow could have started moving some of its reserves into other currencies. An EU official says that given reports Moscow had started placing orders, the measures needed to be ready by the time the markets opened on Monday so that banks would not process any trades.
“We took the Russians by surprise — they didn’t pick up on it until too late,” the official says.
According to Adeyemo at the US Treasury: “We were in a place where we knew they really couldn’t find another convertible currency that they could use and try to subvert this.”
The last-minute talks caught some western allies off guard — forcing them to scramble to implement the measures in time. In the UK, they triggered a frantic weekend effort by British Treasury officials to finalise details before the markets opened in London at 7am on Monday. Chancellor Rishi Sunak communicated by WhatsApp with officials through the night, with the work only concluding at 4am.
No clear political strategy
Yet if the western response has been defined by unity, there are already signs of potential faultlines — especially given the new claims about war crimes, which have prompted calls for further sanctions.
Western governments have not defined what Russia would need to do for sanctions to be lifted, leaving some of the difficult questions about the political strategy for a later date. Is the objective to inflict short-term pain on Russia to inhibit the war effort or long-term containment?
Even when they work, sanctions take a long time to have an impact. However, the economic pain from the crisis is being unevenly felt, with Europe suffering a much bigger blow than the US.
Europe has so far been reluctant to impose an oil and gas embargo, given the bloc’s high dependence on Russian energy imports. But since the atrocities allegedly perpetrated by Russian soldiers in the suburbs of Kyiv have been revealed, a fresh round of EU sanctions was announced on Tuesday that will include a ban on Russian coal imports and, at a later stage, possibly also oil. A decision among the 27 capitals is expected later this week.
The other key factor is whether the west can win the narrative contest over sanctions — both in Russia and in the rest of the world.
Speaking in 2019, Singh, the White House official, admitted that sanctions imposed on Russia after Crimea were not as effective as hoped because Russian propaganda succeeded in blaming the west for economic problems.
“Our inability to counter Putin’s scapegoating,” he told Congress, “gave the regime far more staying power than it would have enjoyed otherwise.”
In the coming weeks and months, Putin will try to convince a Russian population undergoing economic hardship that it is the victim, not the aggressor.
To China, India, Brazil and the other countries which might potentially help him evade the western sanctions, Putin will pose a deeper question about the role of the US dollar in the global economy: can you still trust America?
Markets often react strongly to geopolitical events, but then later shrug them off. Not this time. Russia’s invasion of Ukraine is a key economic turning point that will have many lasting consequences. Among them will be a quickening of the shift to a bipolar global financial system — one based on the dollar, the other on the renminbi.
The process of financial decoupling between Russia and the west has, of course, been going on for some time. Western banks reduced their exposure to Russian financial institutions by 80 per cent following the country’s annexation of Crimea in 2014, and their claims on the rest of Russia’s private sector have halved since then, according to a recent Capital Economics report. The new and more aggressive sanctions announced by the US will take that decoupling much further.
It will also make Russia much more dependent on China, which will use the US and EU sanctions as an opportunity to pick up excess Russian oil and gas on the cheap. China is no fan of Vladimir Putin’s war. But it needs Russian commodities and arms, and sees the country as a key part of a new Beijing-led order, something Moscow is aware of.
“China is our strategic cushion,” Sergei Karaganov, a political scientist at the Moscow-based Council on Foreign and Defense Policy, told Nikkei Asia recently. “We know that in any difficult situation, we can lean on it for military, political and economic support.”
That does not mean China would break US or European sanctions to support Russia, but it could certainly allow Russian banks and companies more access to its own financial markets and institutions. Indeed, just a few weeks ago, the two countries announced a “friendship without limits”, one that will certainly include closer financial ties as Russia is shut out of western markets. This follows a 2019 agreement between Russia and China to settle all trade in their respective currencies rather than in dollars. The war in Ukraine will speed this up. Witness, in the past few days, China lifting an import ban on Russian wheat, as well as a new long-term Chinese gas deal with Gazprom.
All of this supports China’s long-term goal of building a post-dollarised world, in which Russia would be one of many vassal states settling all transactions in renminbi. Getting there is not an easy process. The Chinese want to de-dollarise, but they also want complete control of their own financial system. That’s a difficult circle to square. One of the reasons that the dollar is the world’s reserve currency is that, in contrast, the US markets are so open and liquid.
Still, the Chinese hope to use trade and the petropolitics of the moment to increase the renminbi’s share of global foreign exchange. One high-level western investor in China told me he expected that share would rise from 2 per cent to as high as 7 per cent in the next three to four years. That is, of course, still minuscule compared with the position of the dollar, which is 59 per cent.
But the Chinese are playing a long game. Finance is a key pillar in the new Great Power competition with America; currency, capital flows and the Belt and Road Initiative trade pathway will all play a role in that. Beijing is slowly diversifying its foreign exchange reserves, as well as buying up a lot of gold. This can be seen as a kind of hedge on a post-dollar word (the assumption being that gold will rise as the dollar falls).
New US limits on capital flows to China on national security grounds may speed up the financial decoupling process further. If US pension funds can’t flow into China, self-sufficiency in capital markets becomes ever more important. Beijing has been trying to bolster trust and transparency in its own system, not only to attract non-US foreign investment, but also to encourage an onshore investment boom in which huge amounts of Chinese savings would be funnelled into domestic capital markets.
While sanctions against Russia herald more decoupling, it is also possible that the economic fallout from the war (lowered demand, even higher inflation) would push America and other nations into succumbing to pricing pressures that would favour Chinese goods. While there is likely to be a lot of political posturing on both sides of the aisle about standing up to Russia and China, it takes a long time to decouple supply chains. Policymakers in Washington have yet to get really serious about it.
Beijing, on the other hand, is quite serious about the new world order that it is pursuing. In his 1997 book, The Grand Chessboard, Zbigniew Brzezinski, the former US national security adviser, wrote presciently that the most dangerous geopolitical scenario for the west would be a “grand coalition of China, Russia, and perhaps Iran”. This would be led by Beijing and united not by ideology but by common grievances. “Averting this contingency, however remote it may be, will require a display of US geostrategic skill on [all] perimeters of Eurasia simultaneously,” he wrote.
Financial markets are going to be a major field of battle. They will become a place to defend liberal values (for example, via sanctions against Russia) and renew old alliances. (Might the US and Europe come together to forge a strategy on both energy security and climate change?) They will also be a lot more sensitive to geopolitics than they have been in the past.
We were warned about Vladimir Putin – about his intentions, his nature, his mindset – and, because it was profitable for us, we ignored those warnings and welcomed his friends and their money. It is too late for us to erase our responsibility for helping Putin build his system. But we can still dismantle it and stop it coming back.
Russia is a mafia state, and its elite exists to enrich itself. Democracy is an existential threat to that theft, which is why Putin has crushed it at home and seeks to undermine it abroad. For decades, London has been the most important place not only for Russia’s criminal elite to launder its money, but also for it to stash its wealth. We have been the Kremlin’s bankers, and provided its elite with the financial skills it lacks. Its kleptocracy could not exist without our assistance. The best time to do something about this was 30 years ago – but the second best time is right now.
We journalists have long been writing about this, but it is not simply overheated rhetoric from overexcited hacks. Parliament’s intelligence and security committee wrote two years ago that our investigative agencies are underfunded, our economy is awash with dirty money, and oligarchs have bought influence at the very top of our society.
The committee heard evidence from senior law enforcement and security officials. It laid out detailed, careful suggestions for what Britain should do to limit the damage Putin has already done to our society. Instead of learning from the report and implementing its proposals, Boris Johnson delayed its publication until after the general election and then, when further delay became impossible, dismissed those who took its sober analysis seriously as “Islingtonian remainers” seeking to delegitimise Brexit.
That is the crucial context for Johnson’s ludicrous claim this week to the House of Commons that no government could “conceivably be doing more to root out corrupt Russian money”. That is not only demonstrably untrue, it is an inversion of reality. On leaving the European Union, we were told that we could launch our own independent sanctions regime – and this week we saw the fruit of it: a response markedly weaker than those of Brussels and Washington.
The Liberal Democrat MP Layla Moran, speaking with parliamentary privilege on Tuesday, listed the names of 35 alleged key Putin “enablers” whom the Russian opposition politician Alexei Navalny has asked to be sanctioned. Blocking the assets of everyone on that list and their close relatives would be a truly significant response from Johnson to the gravity of the situation. But it would still only be a start.
Relying solely on sanctions now is like stamping on a car’s accelerator when you’ve failed for years to maintain the engine, pump up the tyres or fill up the tank, yet still expect it to hit 95mph. Other announcements in the last couple of days have amounted to nothing more than painting on go-faster stripes. Tackling the UK’s role in enabling Putin’s kleptocracy, and containing the threat his allies pose to democracy here and elsewhere, will require far more than just banning golden visas or Kremlin TV stations.
For a start, we need to know who owns our country. Some 87,000 properties in England and Wales are owned via offshore companies – which prevents us seeing who their true owners are or if they were bought with criminal money. Companies House makes no checks on registrations, which is why UK shell structures have featured in most Russian money-laundering scandals. Imposing transparency on the ownership of dirty money in this way would strike at the heart of the London money-laundering machine. Governments have promised to do this “when parliamentary time allows” for years, yet the time has never been found, and instead they’ve listened to concerns from the City that such regulations would harm its competitiveness.
Above all, we need to fund our enforcement agencies as generously as oligarchs fund their lawyers: you can’t fight grand corruption on the cheap. Even good policies of recent years, such as the “unexplained wealth orders” of 2017, which were designed to tackle criminally owned assets hidden behind clever shell structures, have largely failed because investigators lack the funds to use them. We must spend what it takes to drive kleptocratic cash out of the country.
Johnson is not the first prime minister to fail to rise to the challenge – Tony Blair and David Cameron both schmoozed with Putin even when it was obvious what kind of a leader he was. And I don’t think Johnson is personally corrupt or tainted by Russian money; he’s lazy, flippant and unwilling to launch expensive, laborious initiatives that will bring results only long after he himself has left office and is unable to take the credit for them. It is time, however, for his colleagues to step up and force him into action. This is a serious moment, and it requires serious people willing to invest in the long-term security of our country and the future of democracy everywhere.
It may sound like a low-budget Blade Runner rip-off, but over the past decade the scientific world has been gripped by a “replication crisis” — the findings of many seminal studies cannot be repeated, with huge implications. Is investing suffering from something similar?
That is the incendiary argument of Campbell Harvey, professor of finance at Duke university. He reckons that at least half of the 400 supposedly market-beating strategies identified in top financial journals over the years are bogus. Worse, he worries that many fellow academics are in denial about this.
“It’s a huge issue,” he says. “Step one in dealing with the replication crisis in finance is to accept that there is a crisis. And right now, many of my colleagues are not there yet.”
Harvey is not some obscure outsider or performative contrarian attempting to gain attention through needless controversy. He is the former editor of the Journal of Finance, a former president of the American Finance Association, and an adviser to investment firms like Research Affiliates and Man Group.
He has written more than 150 papers on finance, several of which have won prestigious prizes. In fact, Harvey’s 1986 PhD thesis first showed how the bond market’s curves can predict recessions. In other words, this is not like a child saying the emperor has no clothes. Harvey’s escalating criticism of the rigour of financial academia since 2015 is more akin to the emperor regretfully proclaiming his own nudity.
To understand what the ‘replication crisis’ is, how it has happened and its implications for finance, it helps to start at its broader genesis.
In 2005, Stanford medical professor John Ioannidis published a bombshell essay titled “Why Most Published Research Findings Are False”, which noted that the results of many medical research papers could not be replicated by other researchers. Subsequently, several other fields have turned a harsh eye on themselves and come to similar conclusions. The heart of the issue is a phenomenon that researchers call “p-hacking”.
In statistics, a p-value is the probability of whether a finding could be because of pure chance — a simple data oddity like the correlation of Nicolas Cage films to US swimming pool drownings — or whether it is “statistically significant”. P-scores indicate whether a certain drug really does help, or if cheap stocks do outperform over time.
P-hacking is when researchers overtly or subconsciously twist the data to find a superficially compelling but ultimately spurious relationship between variables. It can be done by cherry-picking what metrics to measure, or subtly changing the time period used. Just because something is narrowly statistically significant, does not mean it is actually meaningful. A trading strategy that looks golden on paper might turn up nothing but lumps of coal when actually implemented.
Harvey attributes the scourge of p-hacking to incentives in academia. Getting a paper with a sensational finding published in a prestigious journal can earn an ambitious young professor the ultimate prize — tenure. Wasting months of work on a theory that does not hold up to scrutiny would frustrate anyone. It is therefore tempting to torture the data until it yields something interesting, even if other researchers are later unable to duplicate the results.
Obviously, the stakes of the replication crisis are much higher in medicine, where lives can be in play. But it is not something that remains confined to the ivory towers of business schools, as investment groups often smell an opportunity to sell products based on apparently market-beating factors, Harvey argues. “It filters into the real world,” he says. “It definitely makes it into people’s portfolios.”
AQR, a prominent quant investment group, is also sceptical that there are hundreds of durable and successful factors that can help investors beat markets, but argues that the “replication crisis” brouhaha is overdone. Earlier this year it published a paper that concluded that not only could the majority of the studies it examined be replicated, they still worked “out of sample” — in actual live trading — and were actually further corroborated by international data.
Harvey is unconvinced by the riposte, and will square up to the AQR paper’s authors at the American Finance Association’s annual meeting in early January. “That’s going to be a very interesting discussion,” he promises. Many of the industry’s geekier members will be rubbing their hands at the prospect of a gladiatorial, if cerebral, showdown to kick off 2022.
Despite so many government promises, we’ve ended up with inadequate laws and toothless regulation. The Pandora papers show why urgent action is needed writes Prem Sikka in The Guardian
'HSBC admitted “criminal conduct” and was fined a record $1.9bn and signed a deferred prosecution agreement.’ Photograph: Lim Huey Teng/Reuters Wed 6 Oct 2021 11.00 BST
The Pandora papers data leak has once again highlighted the predatory practices of the world’s political and financial elites – enriching themselves by looting the public purse, or exploiting laws which they themselves helped to establish.
Aabout $3.6tn (£2.6tn) of the proceeds from bribery, embezzlement, money laundering, tax evasion and cronyism are laundered each year, undermining the social fabric of nations across the globe.
It is not the first time that tax avoidance, bribery, corruption, money-laundering and a lack of transparency have been exposed. The Panama papers, the Paradise papers, the HSBC leaks, the Jersey leaks, the FinCEN files, the Bahamas leaks and others have provided abundant evidence of dodgy financial dealings. The UK finance industry – aided by armies of accountants, lawyers and finance experts – is central to this trade, yet little has changed since those first revelations emerged.
The inertia is institutionalised because the political system is available for hire to people with fat wallets. Financial contributions to political parties create an atmosphere where scrutiny, and unwelcome laws, are discouraged. As Mohamed Amersi, who funded Boris Johnson’s campaign to become prime minister and whose financial dealings were revealed this week, puts it: “You get access, you get invitations, you get privileged relationships, if you are part of the setup.”
Further, parliament’s register of members’ financial interests shows that too many MPs and lords are on the payroll of corporations, including some engaged in illicit financial flows. The inevitable outcome is poor laws and a lack of regulation.
In 2018, the government launched the national economic crime centre to tackle high-level fraud and money laundering. The centre has yet to prosecute a single case – even though there is plenty of evidence of wrongdoing. In some cases, banks may even have forged customer signatures on court documents used to repossess homes and recover debts.
The 2017 Criminal Finances Act introduced the offence of failure to prevent the facilitation of tax evasion. No corporate body has been prosecuted. Little has been done to shackle the tax abuses industry dominated by big accounting firms even though, on some occasions, judges have declared their avoidance schemes to be unlawful. Despite the potential loss of huge amounts of tax revenues, no major firm has been investigated, fined or prosecuted. On the contrary, they continue to advise government departments, and sometimes receive lucrative government contracts.
The 2010 Bribery Act introduced the offence of “failure to prevent bribery”, to enable regulators to sue corporations for corrupt practices. The Crown Prosecution Service has secured just one conviction. The under-resourced Serious Fraud Office has secured just one conviction after the company itself pleaded guilty. Separately, Standard Chartered Bank, Rolls-Royce and four other companies were effectively let off with a deferred prosecution agreement.
The UK political system excels at cover-ups and protects wrongdoers. In 2012, a US Senate committee documented HSBC’s involvement in money laundering. The bank admitted “criminal conduct” and was fined a record $1.9bn and signed a deferred prosecution agreement. Yet though HSBC was supervised by the Bank of England and the Financial Services Authority, there was no UK investigation.
Later, a letter emerged from the then chancellor George Osborne, along with correspondence from the governor of the Bank of England and the Financial Services Authority, urging the US authorities to go easy on HSBC as it was too big to jail. There was no ministerial statement in the UK parliament to explain the cover-up.
The Bank of Commerce and Credit International (BCCI) was closed by the Bank of England in 1991. It was the biggest banking fraud of the 20th century, yet the then Conservative government did not order an independent investigation. Through US investigations I became aware of a secret document codenamed the Sandstorm Report. Using freedom of information laws I requested a copy: the government refused. After five and half years of litigation, judges ordered the UK government to release a copy to me. It shows that the government has been protecting individuals, including dead ones, connected with al-Qaida, Saudi intelligence, royal families in the Middle East, smuggling, murder, financial crimes and other nefarious practices.
The UK remains a favourite destination for dirty money because the political and regulatory system is ineffective. An independent public inquiry into the finance industry is long overdue, but even if one were granted it would be hard to be optimistic: it seems our law enforcement agencies have been captured by corporations. The revelation that the City of London police fraud investigation unit is now funded by Lloyds Bank – an organisation severely criticised by the all-party parliamentary group on fair business banking for its role in the unresolved frauds at HBOS – does not inspire any confidence. Will it take another financial crash to generate enough political pressure to change the system?
The strategy that once worked for Keynes and Buffett has performed badly writes Robin Wigglesworth in The Financial Times When Joel Greenblatt went to Wharton Business School in the late 1970s, the theory of “efficient markets” was in full bloom, approaching the point of becoming dogma among the financial cognoscenti. To the young student, it all felt bogus. Mr Greenblatt had already developed a taste for calculated gambles at the dog racing tracks. Reading the wildly fluctuating stock prices listed in newspapers also made him deeply sceptical of the supposed rationality of markets. One day he stumbled over a Fortune article on stockpicking, and everything suddenly fell into place. “A lightbulb went off. It just made sense to me that prices aren’t necessarily correct,” recalls Mr Greenblatt, whose hedge fund Gotham Capital clocked up one of the industry’s greatest ever winning streaks until it was closed to outside investors in 1994. “Buying cheap stocks is great, but buying good companies cheaply is even better. That’s a potent combination.” The article became his gateway drug into a school of money management known as “value investing”, which consists of trying to identify good, solid businesses that are trading below their fair value. The piece was written by Benjamin Graham, a financier who in the 1930s first articulated the core principles of value investing and turned it into a phenomenon. One of Graham’s protégés was a young money manager called Warren Buffett, who brought the value investing gospel to the masses. But he isn't the only one to play a role in popularising the approach. Since 1996, Mr Greenblatt has taught the same value investing course started by Graham at Columbia Business School nearly a century ago, inculcating generations of aspiring stock jocks with its core principles. Mr Greenblatt compares value investing to carefully examining the merits of a house purchase by looking at the foundation, construction quality, rental yields, potential improvements and price comparisons on the street, neighbourhood or other cities. “You’d look funny at people who just bought the houses that have gone up the most in price,” he points out. “All investing is value investing, the rest is speculation.” However, the faith of many disciples has been sorely tested over the past decade. What constitutes a value stock can be defined in myriad ways, but by almost any measure the approach has suffered an awful stretch of performance since the 2008 financial crisis. Many proponents had predicted value investing would regain its lustre once a new bear market beckoned and inevitably hammered the glamorous but pricey technology stocks that dominated the post-2008 bull run. This would make dowdier, cheaper companies more attractive, value investors hoped. Instead, value stocks have been pummelled even more than the broader market in the coronavirus-triggered sell-off, agonising supporters of the investment strategy. “One more big down leg and I’m dousing my internal organs in Lysol,” Clifford Asness, a hedge fund manager, groused in April. Value investing has gone through several bouts of existential angst over the past century, and always comes back strongly. But its poor performance during the coronavirus crisis has only added to the crisis of confidence. The strength and length of the recent woes raises some thorny questions. Why has value lost its mojo and is it gone forever? Search for ‘American magic’ Berkshire Hathaway’s annual meeting is usually a party. Every year, thousands of fans have flocked to Omaha to lap up the wisdom of Mr Buffett and his partner Charlie Munger, the acerbic, terse sidekick to the conglomerate’s avuncular, loquacious chairman. Last weekend’s gathering was a more downbeat affair. A shaggy-haired Mr Buffett sat alone on stage without his usual companion, who was stranded in California. Instead of Mr Munger, Greg Abel, another lieutenant, sat at a table some distance away from Berkshire’s chairman. Rather than the 40,000 people that normally fill the cavernous CHI Health Center for the occasion, he faced nothing but a bunch of video cameras. It was an eerie example of just how much the coronavirus crisis has altered the world, but the “Oracle of Omaha” tried to lift spirits. “I was convinced of this in World War II. I was convinced of it during the Cuban missile crisis, 9/11, the financial crisis, that nothing can basically stop America,” he said. “The American magic has always prevailed, and it will do so again.” Berkshire’s results, however, underscored the scale of the US economy’s woes. The conglomerate — originally a textile manufacturer before Mr Buffett turned it into a vehicle for his wide-ranging investments — slumped to a loss of nearly $50bn in the first three months of the year, as a slight increase in operating profits was swamped by massive hits on its portfolio of stocks. A part of those losses will already have been reversed by the recent stock market rally triggered by an extraordinary bout of central bank stimulus, and Mr Buffett’s approach has over the decades evolved significantly from his core roots in value investing. Nonetheless, the worst results in Berkshire’s history underscore just how challenging the environment has been for this approach to picking stocks. After a long golden run that burnished Mr Buffett’s reputation as the greatest investor in history, Berkshire’s stock has now marginally underperformed the S&P 500 over the past year, five years and 10 years. But the Nebraskan is not alone. The Russell 3000 Value index — the broadest measure of value stocks in the US — is down more than 20 per cent so far this year, and over the past decade it has only climbed 80 per cent. In contrast, the S&P 500 index is down 9 per cent in 2020, and has returned over 150 per cent over the past 10 years. Racier “growth” stocks of faster-expanding companies have returned over 240 per cent over the same period. Ben Inker of value-centric investment house GMO describes the experience as like being slowly but repeatedly bashed in the head. “It’s less extreme than in the late 1990s, when every day felt like being hit with a bat,” he says of the dotcom bubble period when value investors suffered. “But this has been a slow drip of pain over a long time. It’s less memorable, but in aggregate the pain has been fairly similar.” Underrated stocks Value investing has a long and rich history, which even predates the formal concept. One of the first successful value investors was arguably the economist John Maynard Keynes. Between 1921 and 1946 he managed the endowment of Cambridge university’s King’s College, and beat the UK stock market by an average of 8 percentage points a year over that period. In a 1938 internal memorandum to his investment committee, Keynes attributed his success to the “careful selection of a few investments” according to their “intrinsic value” — a nod to a seminal book on investing published a few years earlier by Graham and his partner David Dodd, called Security Analysis. This tome — along with the subsequent The Intelligent Investor, which Mr Buffett has called “the best book about investing ever written” — are the gospel for value investors to this day. There are ways to define a value stock, but it is most simply defined as one that is trading at a low price relative to the value of a company’s assets, the strength of its earnings or steadiness of its cash flows. They are often unfairly undervalued because they are in unfashionable industries and growing at a steadier clip than more glamorous stocks, which — the theory goes — irrational investors overpay for in the hope of supercharged returns. Value stocks can go through long fallow periods, most notably in the 1960s — when investors fell in love with the fast-growing, modern companies like Xerox, IBM and Eastman Kodak, dubbed the “Nifty Fifty” — and in the late 1990s dotcom boom. But each time, they have roared back and rewarded investors that kept the faith. “The one lesson we’ve learnt over the decades is that one should never give up on value investing. It’s been declared dead before,” says Bob Wyckoff, a managing director of money manager Tweedy Browne. “You go through some uncomfortably long periods where it is not working. But this is almost a precondition for value to work.” The belief that periodic bouts of suffering are not only unavoidable but in fact necessary for value to work is entrenched among its adherents. It is therefore a field that tends to attract more than its fair share of iconoclastic contrarians, says Chris Davis of Davis Funds, a third-generation value investor after following in the footsteps of his father Shelby MC Davis and grandfather Shelby Cullom Davis.
“If you look at the characteristics of value investors they don’t have a lot in common,” he says. “But they all tend to be individualistic in that they aren’t generally the type who have played team sports. They weren’t often president of their sororities or fraternities. And you don’t succeed without a fairly high willingness to appear wrong.” But why have they now been so wrong for so long? Most value investors attribute the length of the underperformance to a mix of the changing investment environment and shifts in the fabric of the economy. The ascent of more systematic, “quantitative” investing over the past decade — whether a simple exchange-traded fund that just buys cheap stocks, or more sophisticated, algorithmic hedge funds — has weighed on performance by warping normal market dynamics, according to Matthew McLennan of First Eagle Investment Management. This is particularly the case for the financial sector, which generally makes more money when rates are higher. The usual price discount enjoyed by value stocks was also unusually small at the end of the financial crisis, setting them up for a poorer performance, according to Mr Inker. Some industries, especially technology, are also becoming oligopolies that ensure extraordinary profit margins and continued growth. Moreover, traditional value measures — such as price-to-book value — are becoming obsolete, he points out. The intellectual property, brands and often dominant market positioning of many of the new technology companies do not show up on a corporate balance sheet in the same way as hard, tangible assets.
“Accounting has not kept up with how companies actually use their cash,” he says. “If a company spends a lot of money building factories it affects the book value. But if you spend that on intellectual property it doesn’t show up the same way.” As a result, GMO and many value-oriented investors have had to adapt their approach, and focus more on alternative metrics and more intangible aspects of its operations. “We want to buy stocks we think are undervalued, but we no longer care whether it looks like a traditional value stock,” Mr Inker says. Mr McLennan points out that while the core principles won’t change, value investing has always evolved with the times. “It’s not a cult-like commitment to buying the cheapest decile [of stocks]. We invest business-by-business,” he says. “I don’t know what the alternative is to buying businesses you like, at prices you like.” Bargain hunt Can value investing stage a comeback, as it did in when the dotcom bubble burst in the early 2000s, or the “Nifty Fifty” failed to justify investor optimism and fell to earth in the 1970s? There has clearly been a shift in the corporate landscape over the past few decades that could be neutering its historical power as an investing approach. It is telling that the recent stock market rebound has been powered primarily by big US technology companies, despite value investors having confidently predicted for a long time that their approach would shine in the next downturn. Value stocks tend to be in more economically-sensitive industries, and given the likelihood of the biggest global recession since the Depression, their outlook is exceptionally murky, according to an AQR paper published last week. “If value investing was like driving my four kids on a long car ride, we’d be very deep into the ‘are we there yet?’ stage of the ride, and value investors are justifiably in a world of pain,” Mr Asness wrote. However, the odds are now “rather dramatically” on the side of value. Redemption could be at hand. there has in recent days been a cautious renaissance for value stocks, indicating that coronavirus may yet upend the market trends of the past decade. This stockpicking approach often does well as economies exit a recession and investors hunt for bargains. Devotees of value investing certainly remain unshakeable in their faith that past patterns will eventually reassert themselves. Citing a common saying among adherents, Mr Wyckoff argues that “asking whether value is still relevant is like asking whether Shakespeare is still relevant. It’s all about human nature”. Mr Greenblatt, who founded Gotham Asset Management in 2008, says that his students will occasionally quiz him on whether value investing is dead, arguing that computers can systematically take advantage of undervaluation far more efficiently than any human stockpicker can. He tells them that human irrationality remains constant, which will always lead to opportunities for those willing to go against the crowd. “If you have a disciplined strategy to value companies, and buy companies when they’re below fair value you will still do well,” he says. “The market throws us pitches all the time, as there are so many behavioural biases . . . You can watch 20 pitches go by, but you only need to try to hit a few of them.”
