I recently watched a video of iconoclast fund-manager, Hugh Hendry, of Electra Asset Management UK, in which he uttered the following interesting hypothesis on the near future (starting 2009) of the UK economy:
I think that I replayed that statement about five times in my mind; contemplating why his hypothesis may be valid/invalid, and here is what I mustered:
The UK is a mature post-industrial or service-based economy, and therefore the majority of its GDP is generated by its services sector; which in this particular case, is its financial services sector. Hence, this implies that state of the UK's economy is a magnified reflection of the prevalent state of the country's financial services sector. Which in turn implies that the UK's economy would be in a bearish state, if its financial services industry is in a state of pandemonium, and/or that the UK's economy would be bullish when the financial services industry is booming.
Currently, the UK's financial services sector is caught in a deadly spiral of evaporating confidence owing to: bank collapses; the development of multiple layers of correlation among 'disparate' securities; a currently-prevailing credit crisis that is exacerbating the economic downturn; the drying-up of liquidity in most security markets and; the widening of spreads.
Therefore, investment entities will be forced to sell the 'liquid' securities in their portfolios to honor client redemption requests; setting-off a chain of negative market events.
...Here is why:
Rapid liquidation of a large chunk of securities, in an environment of high market volatility, would move market prices downwards. Which would inturn trigger a chain of margin calls, as the counter-parties of market-players demand more collateral; precipitating another wave of forced-selling of securities; which sets into motion a self-magnifying & self-reinforcing downward movement of prices across an array of 'liquid' securities in the market-player's portfolio. Hence, in such a scenario, forced selling of securities would trigger margin calls; and margin calls would in turn trigger even more forced selling of securities; which would consequentially trigger another wave of margin calls, and so on. Generally, when this positive-feedback loop is at play, observed market prices of securities increasingly deviate away from the fundamental/intrinsic prices of the securities.
Furthermore, a portfolio's structure morphs (in an environment of; limited asset inflows - the UK fund management industry's aggregate AUM has fallen 11% to 339 billion pounds year to date, high-volatility, and increasing market illiquidity) when 'liquid' assets are continually being sold-off to meet client redemption requests and counter-party demands for more collateral. This therefore implies that the original investors of a portfolio will eventually end-up with an unbalanced portfolio; which is structurally different to the portfolio they invested in, and is largely comprised of illiquid assets.
Hence, this may set into motion, a second wave of redemption requests (who wants to keep what they don't like?), which triggers an acute pernicious cycle of: sell security - > margin-call + redemption request - > sell security - > margin-call + redemption request, and so on. This sends markets into a tailspin that is difficult to arrest.
Continual forced security liquidations, against the backdrop of a volatile market, generally have a security-price-reducing multiplier effect, which iterates itself across different security markets in an economy, and (in the case of the UK) may culminate in the manifestation of a secular economic downturn.
The duration and intensity of this downturn is largely dependent of the extent of overlap between the portfolios of entities that trade the entire spectrum of UK-issued securities; where the extent of overlap is positively correlated to the magnitude, intensity and length of the economic downturn, i.e. the greater the overlap, the more protracted the economic downturn.
Investment strategies of different market players are increasingly becoming homogeneous because of two factors; 1) investment entities that invest in UK-issued securities generally have common lineage (or the same DNA) which leads to an overlap of investment focus, and 2) Increasing imitation of strategies of alpha-entities (by beta-market players) that invest in UK-issued securities also results in a growing level of portfolio overlap.
Therefore, from a systems theory perspective i.e when we postulate that financial markets are engineered systems, UK securities markets can be considered to be deterministic i.e. they are not stochastic, although they generate what may at times, appear to be random behavior. Deterministic systems are generally slower (than stochastic) systems when it comes to dissipating extreme perturbations, and are therefore prone to entrainment. Otherwise stated: the economic downturn in the UK may be protracted, and the downturn may increase in intensity!
Therefore in my view, Hendry's hypothesis is correct!
Wither the UK markets? Answer: Secular bust!
'The UK economy is due for its worst round of deflation since the great depression.'
I think that I replayed that statement about five times in my mind; contemplating why his hypothesis may be valid/invalid, and here is what I mustered:
The UK is a mature post-industrial or service-based economy, and therefore the majority of its GDP is generated by its services sector; which in this particular case, is its financial services sector. Hence, this implies that state of the UK's economy is a magnified reflection of the prevalent state of the country's financial services sector. Which in turn implies that the UK's economy would be in a bearish state, if its financial services industry is in a state of pandemonium, and/or that the UK's economy would be bullish when the financial services industry is booming.
Currently, the UK's financial services sector is caught in a deadly spiral of evaporating confidence owing to: bank collapses; the development of multiple layers of correlation among 'disparate' securities; a currently-prevailing credit crisis that is exacerbating the economic downturn; the drying-up of liquidity in most security markets and; the widening of spreads.
**********************
Quite a number of United Kingdom-based market players still have toxic and illiquid subprime-mortgage-backed securities on their balance sheets (which would be practically impossible to 'park into' the portfolio of a government-sponsored market stabilization investment fund all at once - because the British government may not have that kind of money; as tax revenue shrinks when an economy is experiencing recessionary pressures, and it would also be irresponsible to finance a bailout of this magnitude through debt issues--just too risky!), and a lot of them have a growing number of asset redemption requests to honor in 2009.Therefore, investment entities will be forced to sell the 'liquid' securities in their portfolios to honor client redemption requests; setting-off a chain of negative market events.
...Here is why:
Rapid liquidation of a large chunk of securities, in an environment of high market volatility, would move market prices downwards. Which would inturn trigger a chain of margin calls, as the counter-parties of market-players demand more collateral; precipitating another wave of forced-selling of securities; which sets into motion a self-magnifying & self-reinforcing downward movement of prices across an array of 'liquid' securities in the market-player's portfolio. Hence, in such a scenario, forced selling of securities would trigger margin calls; and margin calls would in turn trigger even more forced selling of securities; which would consequentially trigger another wave of margin calls, and so on. Generally, when this positive-feedback loop is at play, observed market prices of securities increasingly deviate away from the fundamental/intrinsic prices of the securities.
Furthermore, a portfolio's structure morphs (in an environment of; limited asset inflows - the UK fund management industry's aggregate AUM has fallen 11% to 339 billion pounds year to date, high-volatility, and increasing market illiquidity) when 'liquid' assets are continually being sold-off to meet client redemption requests and counter-party demands for more collateral. This therefore implies that the original investors of a portfolio will eventually end-up with an unbalanced portfolio; which is structurally different to the portfolio they invested in, and is largely comprised of illiquid assets.
Hence, this may set into motion, a second wave of redemption requests (who wants to keep what they don't like?), which triggers an acute pernicious cycle of: sell security - > margin-call + redemption request - > sell security - > margin-call + redemption request, and so on. This sends markets into a tailspin that is difficult to arrest.
Continual forced security liquidations, against the backdrop of a volatile market, generally have a security-price-reducing multiplier effect, which iterates itself across different security markets in an economy, and (in the case of the UK) may culminate in the manifestation of a secular economic downturn.
The duration and intensity of this downturn is largely dependent of the extent of overlap between the portfolios of entities that trade the entire spectrum of UK-issued securities; where the extent of overlap is positively correlated to the magnitude, intensity and length of the economic downturn, i.e. the greater the overlap, the more protracted the economic downturn.
Investment strategies of different market players are increasingly becoming homogeneous because of two factors; 1) investment entities that invest in UK-issued securities generally have common lineage (or the same DNA) which leads to an overlap of investment focus, and 2) Increasing imitation of strategies of alpha-entities (by beta-market players) that invest in UK-issued securities also results in a growing level of portfolio overlap.
Therefore, from a systems theory perspective i.e when we postulate that financial markets are engineered systems, UK securities markets can be considered to be deterministic i.e. they are not stochastic, although they generate what may at times, appear to be random behavior. Deterministic systems are generally slower (than stochastic) systems when it comes to dissipating extreme perturbations, and are therefore prone to entrainment. Otherwise stated: the economic downturn in the UK may be protracted, and the downturn may increase in intensity!
Therefore in my view, Hendry's hypothesis is correct!
Wither the UK markets? Answer: Secular bust!
