The third quarter of 2024 saw a surge in downward volatility that raised alarms in the media and among excitable types on Wall Street. (Upward volatility, by contrast, produces a calming effect.) Several days of sharp fluctuations included index declines of 3%, translating into a thousand points in the Dow Jones Industrial Average. The US was not alone in experiencing a sudden change in financial market sentiment; Japan’s equity market fell 12% in one day in response to the country’s central bank raising interest rates. In Japan, as it turns out, speculators from around the world had been borrowing money, taking advantage of ultra-low lending rates, and then using the funds in other markets offering higher yields, pocketing the difference. This so-called “carry trade” leaves the borrowers exposed to changing interest rate differentials, not to mention unpredictable exchange rate fluctuations. Like many speculative financial schemes, it works—until it doesn’t. This summer’s interest rate changes forced players to unwind their positions en masse (the carry trade totaled hundreds of billions of dollars), impacting markets everywhere. As one Wall Street sage once put it, when the tide goes out, you’ll find out who’s been swimming naked.
The average person is blissfully unaware of games—such as those described above—played in the financial world (until something goes wrong necessitating taxpayer bailouts). The latest market setbacks—while exciting (and to many stressful) to watch—seldom result in anything of consequence to the economy or most retirement portfolios. Things usually stabilize after a period, and, sure enough, the markets calmed, and the averages moved on to new highs later in August. As is often the case, the summer’s turmoil was a non-event to those who keep a cool head. Staying the course as portfolio values evaporate is difficult, but, as sailors know to keep an eye on the horizon to avoid sea sickness in rough weather, investors should look to a distant time-horizon to maintain equanimity in the face of market storms.
One of these days, an unexpected economic or political upheaval will produce a more serious and long-lasting reaction in the financial markets. History is replete with many episodes where events wreaked havoc upon widely-used investment strategies as well as the financial expectations and planning of many people. That such events don’t happen frequently is fortunate, but preparation—for example, having ample cash reserves—is essential. Even when challenges are not short-lived, preparedness enables investors to stay calm, and puts them in a position of strength to profit from market folly; in fact, seeds for the best investment results are sown during panics.
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Being a “better ancestor than descendant” is challenging, as most people have trouble seeing beyond the fleeting moment, much less to the distant future. While nothing is for eternity, civilization demands that we create societal structures that endure in order to meet our needs going forward. Eventually, a sense of permanence arises as people accustom themselves to the established order. For example, our constitutional republic, despite its founders’ doubts, has endured for almost two and one-half centuries; most of us cannot imagine a world in which it does not provide a framework for our lives.
Our financial system is part of that established order, one whose importance is often underestimated as long as it functions properly. Much of the financial system as we know it developed over time in response to problems that demanded collective solutions. A series of disruptive depressions led to creation of the Federal Reserve System. The inconvenience of having local banks issue their own notes was solved by the creation of a federal currency. Banks themselves tended to be local institutions supported by well-to-do individuals, and vulnerable to economic shocks. Regulations and deposit insurance made for a safer system in which individuals needn’t fear depositing their savings. Trading of debt instruments and stocks evolved as the country industrialized, and stock exchanges came to play an important role in financing the economy. It may be surprising to many that financial innovations involving housing finance or payments are relatively recent creations, having made their appearance after the Great Depression. Hence, we view it as historical ignorance when people complain about such things as the power of the Federal Reserve Board or the inconvenience of financial regulations, since what came before was far worse.
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The tendency to easily adapt to conditions that have been with us for a while runs into trouble when the conditions are inherently unstable. A fault in the earth’s crust can remain quiet for decades before causing a destructive earthquake; similarly building in wildfire-prone areas seems safe until a downed power line sparks a conflagration. The ultra-low (even negative) interest rates that prevailed in much of the industrial world for more than a decade after the 2008 financial crisis spawned many adaptations growing out of the “reach for yield” phenomenon that led many impatient people (who had too much money) into financial wildfire zones. The consequences can be dramatic, as we saw recently in the Japanese carry trade debacle; but other more subtle effects can over time have a termitic impact on future business health.
Take “financial engineering,” for example, which aims to make corporate balance sheets more “efficient” (balancing the costs of equity and debt financing). At times in recent years, the U.S. stock markets have been supported to a significant degree by the large number of corporate stock repurchases encouraged by among other things—such as lower corporate taxes and executive stock incentives—low borrowing costs. Many companies have issued bonds and used the proceeds for open market purchases of stock. Corporations have spent trillions of dollars for this purpose; one study indicated that S&P 500 companies spent $4.3 trillion, or 52% of net income, on these purchases between 2009 and 2018. Instead of boosting the value of executive stock options or quarterly mutual fund “performance,” this astounding amount of capital could have gone to enhancing future productive capacity, product innovation, or just as important, human resources—short-term stock price gains at the risk of business pain in the long run. Yet adding this “leverage,” as debt is known in corporation finance, is seen as a tax-efficient use of company balance sheets.
The movement of capital into private equity (aka PE) funds, currently de rigeur in the investment world, is another instance of cheap money inflating yet another financial bubble. Such funds purchase non-publicly traded companies, and take publicly-traded companies, or pieces of public companies, private (the idea being that when such businesses are removed from public company regulation and the demands of pesky investors, they can be improved, made more profitable, and sold at a profit, often back to public shareholders). Theoretically, such operations offer higher returns than found in public instruments. That may have been the case when the PE industry was smaller, but now with trillions of dollars at their disposal, and more coming all the time (funds available to PE firms tripled between 2016 and 2022), there is too much money chasing fewer deals, a situation that erodes returns. In the meantime, PE has insinuated itself into almost all aspects of economic life and brought financialization to areas that traditionally operated under different motives, such as medical practices. Furthermore, the veracity of the claimed benefit of PE—bringing expertise to bear to spruce up businesses—is subject to debate.
The Financial Times’ Gillian Tett recently wrote about finance’s “deeply abnormal state” (i.e., low interest rates) and its impact on the normally somnolent life insurance industry. Life insurers take in customer money, invest it, charge fees, and pay out annuities. An important aspect of the business involves the returns on the investments backing the annuity payments. With low rates on fixed income, a staple of life insurer portfolios, the companies, in a “desperate search for yield,” have turned to higher risk investment alternatives, including private equity products that, while illiquid, offer higher returns. In addition, PE firms, flush with cash, have bought into the insurance industry, either piecemeal or through outright acquisition. This has created a situation in which owners of insurance companies also created the investment vehicles used by the same companies, a conflict of interest that increases the risk of unexpected losses when the interest rate environment changes, which it inevitably will.
There were good reasons for keeping interest rates low; inflation was low, and there was a lot of slack in the economy. In the aftermath of the financial crisis and pandemic periods, low rates may have prevented the world from slipping into a depression, but the impact of abnormally low interest rates can be seen in the financial practices described above, and we will continue to deal with the consequences in the years to come.
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Finally, we have noted with some amusement how gold has become popular among the central banks of the world, even as prices have reached record highs of around $2,700 per ounce. The institutions bought 483 tons of the metal in the first six months of 2024, a record for any first half. About 25 years ago the “precious” metal’s price reached a nadir, at about $260 per ounce, amid heavy central bank selling. Central banks may have different motives for buying gold than a typical investor, but preservation of capital from the ravages of inflation does not appear to be among them. Incidentally, since the late 1990s gold has more than fulfilled its traditional role as a store of value, proving once again that the price paid is everything.
Dennis Butler, MBA, CFA
Commentary