China dominates the headlines. Its policy actions and economic data releases move global markets more than ever. While global investors are right to keep a close eye on the world’s second-largest economy, a bird’s-eye view reveals some broader investment trends.
Consider a premise that underlies investments based on macroeconomic and corporate fundamentals: Market inefficiencies exist, and distorted prices will eventually revert to intrinsic value. For successful investing, of course, selecting profitable investments is key. In practice, however, it’s also essential to avoid two types of mismatches.
First, investors must be able to preserve their capital long enough to realize returns from their investment strategies; financing long-term investments with short-term capital is preposterous. Second, if investments are leveraged with short-term debt financing, it’s critical that borrowed capital can be stably refinanced until the investment strategy comes to fruition. Indeed, this mismatch was behind the collapse of Long-Term Capital Management in 1998.
Avoiding mismatches such as these has become more challenging as the global investment landscape has undergone dramatic secular change. Start with emerging countries. China has been liberalizing its capital and financial markets, increasing its influence on global markets. Beijing’s hard-to-predict policies and questionable economic indicators only amplify its impact. Then there’s the upsurge of geopolitical risks – from rising nationalism to instability in the Middle East and Russia.
In developed countries, monetary policy rates are near zero, undermining the capacity of central banks to respond to a future crisis. Some central banks are experimenting with negative policy rates, challenging the conventional wisdom of so-called zero-bound policy rates. However, the economic benefits and associated costs and risks of negative policy rates remain highly uncertain. Also, banks and securities firms have been shrinking their balance sheets since the collapse of Lehman Brothers in 2008.
These trends threaten the matching necessary for fundamental investment. They increase market volatility and prolong market inefficiencies, extending the horizon needed for prices to converge to intrinsic value. Smaller balance sheets among financial institutions make leveraged investment more challenging; refinancing has become less stable.
The bottom line is that fundamental-based investments will require a longer time commitment and investors should therefore allocate capital accordingly. In selecting investment managers, investors should also be aware that skill in portfolio construction and risk management still has the potential to mitigate volatile investment performance. This should remain an important differentiating factor.
A version of this blog post appeared in Japanese in the Nikkei on 19 January 2016.