In his long awaited review of the functioning of the UK equity market, published two weeks ago, Prof John Kay highlighted the short termism and lack of engagement displayed by many professional investors towards their holdings of corporate equity. As could be expected from such a source, his points were elegantly and forcefully argued, even if his recommendations for redress have not found universal favour.
To my mind however, the short termism debate also raises however a related and in some ways more topical and troubling question, which is: how effectively are professional investors coping with the challenge posed by the most pressing and complex global issue currently weighing on the financial markets’ mind. That of course is the future of the Eurozone, and the short answer, I fear, is not at all well.
There are plenty of signs that professional investors are starting to suffer, in much the same way as politicians and voters across the Eurozone, from various forms of crisis fatigue. One problem is simply the difficulty of making money in the increasingly correlated, risk on risk off markets for which the Eurozone’s travails are the most powerful contributory factor. Last week Louis Bacon, the celebrated hedge fund manager, blamed his decision to return $2 billion of capital to investors on of the difficulty of finding and exploiting winning bets in this trading environment.
Noting that both liquidity and opportunities have become heavily “constrained”, he referred specifically to the problems of the Eurozone and what he called the prevalence of “disaster economics”, in which assets are priced not according to their individual merits, but solely on how resilient they might prove in the event of a fresh market crisis. That is just one example of a more generalised problem: according to Standard & Poor’s, 2011 was the worst year yet for active managers in recent times, with 80% of large cap US mutual funds failing to beat their relevant index.
Last week also we heard from Michael Dobson, the chief executive of Schroders, how many institutional clients are simply sitting on their hands, unwilling or unable to commit their cash while the present climate of uncertainty persists. Analysis by academics in San Francisco have meanwhile specifically linked the increasingly high correlation of stocks in today’s “risk on, risk off” market environment to the high degree of policy uncertainty, most of which stems directly from the inability of political leaders in the Eurozone to resolve the seemingly never-ending single currency crisis.
Investor inertia or paralysis, if you want to use a more robust description, is also of course behind the very low volumes of trading activity which are slowly squeezing the life out of many smaller stockbroking firms. Not that the markets are helping themselves in this regard. The excitable way in which both the bond and equity markets have reacted to the “will he, won’t he” bond buying plan of the European Central Bank’s President Mario Draghi underlines just how superficial and short termist investors can be. Years of taking a supine lead from the actions of the Federal Reserve seem to have lulled many analysts into investing the ECB, for example, with far more authority in Europe than it in fact possesses, either in theory or in practice.
It was remarkable how quickly and how willingly investment banking analysts took Mr Draghi’s carefully worded remarks in his interview ten days ago to mean that the European Stability Mechanism, the Eurozone’s planned new bailout fund, was just about to be given a banking licence and the ability to borrow many times its initial capital to support Spanish and Italian bonds, thereby – hey presto – saving the Eurozone from collapse. The severity of the market reaction, swinging quickly from euphoria to disappointment, implies that this reasoning was quite widely believed.
In practice the issue is nothing like so simple, and never has been. Even overlooking the fact that the ESM does not yet exist, has no staff and no capital, the reality is that it has never been in the ECB’s power to initiate or orchestrate such an initiative. Even if you accept that some such development is the best hope of solving the Eurozone crisis (itself a debatable hypothesis), it will ultimately only be allowed if Europe’s divided political leaders can find sufficient consensus to sanction the move, which in turn will ultimately require treaty change and ratification by the Eurozone’s 17 different members.
It is far from clear that they can do this in time to prevent at least partial fragmentation. The reason however that the Eurozone issue is such a challenge to the markets is because it is ultimately a political issue whose outcome carries both serious short term risks and profound long term consequences – none of which plays to professional investors’ traditional strengths, or particularly suits their preferred methods of analysis. No wonder everyone is praying that one way or another it will be over soon.
Jonathan Davis 