The tailwind of economic growth that drove our economy to new heights for the past thirty years has disappeared, according to Curtis Arledge during his session at the MMI 2011 Fall Solutions Conference. The source of the tailwind was the extraordinary amount of debt taken on by the government, corporations and individuals, which reached levels not seen since the Great Depression, he emphasized.
Curtis, who is Vice Chairman and Chief Executive Officer, Investment Management at BNY Mellon, explained that the ratio of our total debt to GDP is at a higher level now than it was in 1929. At that time, the debt to GDP ratio reached a peak of 2.3x (in other words, $2.30 of debt for every $1.00 of GDP). After the market crashed, he added, it took almost 50 years for the economy to deleverage down to 1.5x.
Starting in the late 1970‘s the ratio started growing again until it reached another peak of over 3.5x in advance of the recent financial crisis in 2008. More than three years later, we’ve only managed to reduce the debt-to-GDP ratio to 3.3x, Curtis observed. At this rate it’s going to take a long time to get back to a safer level.
Every time we had a problem in our economy, from the 1980’s until 2007, the solution was to create some new form of leverage. This acted like a tailwind to our economic growth. The events of 2008 demonstrated that new leverage solutions aren’t the answer anymore, Curtis emphasized.
The rest of the developed world has similar debt problems and they’re also trying to reduce their debt-to-GDP ratios. This global deleveraging will dampen future growth, Curtis noted. Risk-based capital faired especially poorly in Britain, where banking assets went from 1x in the early 1800’s to 6x the size of the entire UK economy by 2007.
Curtis noted that the process of reducing our debt load won’t be as bad for us as it was for Japan after the 80’s boom, since our economy is more multinational. Our economy benefits from being able to move assets around the globe as needed. This will shorten the deleveraging cycle, he predicted.
The Growth of ETFs
80% of global assets under management is in concentrated in the US and Western Europe. Most assets in the rest of the world are held on bank balance sheets because banks were the only providers of capital. ETFs are helping to change that by opening up overseas markets and bringing in more outside investment. The result has been tremendous growth of the passive investments industry. Curtis pointed out that the price of access to Beta is falling fast.
The use of ETFs has been growing in managed accounts, as I wrote about in a prior blog posting, Managed Accounts: Future Trends, Projections and Opportunities.
While the assets invested in ETFs globally has surpassed $1 trillion, they have begun to attract attention from regulators, especially after a suspected rogue trader managed to lose $2.3 billion at UBS and tried to cover his tracks using fictitious ETF trades. ETFs have also facilitated insider trading, as explained in this blog post from the Reuters Financial Regulatory Forum:
Also of concern for regulators is “ETF stripping,” wherein a trader with non-public information purchases (or sells short) an ETF representing an index of securities, and then shorts (or buys) all of its constituents except the one about which he or she has non-public information, amounting to a disguised position in a single security.
Advisor and investor technology platforms are improving at exponential rates. Generation Y and Millenials won’t invest the same way as previous generations did, Curtis said. Technology is not only democratizing access to the world’s best investment managers but also allowing investors to easily see the alpha-beta separation in the marketplace. Firms that delver sub-par performance won’t be able to survive for very long. They also won’t be able to distract investors from their failings with flashy advertising campaigns.
For the past 30 years, the investment management industry has spent their marginal dollars on asset gathering. To be successful in the new paradigm, these marginal dollars should instead be spent on improving investing, Curtis warned. Security analysis and basic research should take priority over marketing, if firms want to be successful.
Back to the Future
Clients are looking to their investment managers for solutions that shield them from volatility in the markets and avoid taking losses in the case of another bear market, Curtis continued. Absolute return products of today are the balanced funds of the past. No one was interested in balanced funds while the tailwind of leverage was driving markets to new heights. In the current environment, where uncertain is the only consistent thing, investors want product that dampen volatility while delivering steady returns., he advised
I found a great chart showing how the price of gold is correlated with increases in the US’s debt limit, particularly in the past ten years. “By increasing the debt limit, more dollars are being printed and circulated. A bigger supply will gradually weaken the dollar and consequently lift the gold price that is quoted in US dollar,” said Paul Stewart, managing director of Plexus Asset Management.