Gillian Tett June 9, 2023 Financial Times
We must think more broadly to grasp today’s financial uncertainties.
This week I attended a dinner party where one guest posed a question that many investors might ask: is it rational to feel optimistic or pessimistic about the future now?
We collectively weighed our collective balance sheet of cheer and gloom; since the gathering in San Francisco included techies, real estate executives and financiers, all used to weighing risks and making forecasts. But, as we sipped our wine, one theme became clear: what was shaping our sentiment was not just tangible modern threats, such as artificial intelligence or inflation — but a profound sense of disorientation too.
“We keep getting hit by shock and shock — it never ends,” one diner lamented, amid nods. Or to put it another way, our mood was marked by a sense of “radical uncertainty”, to cite the title of a book penned by Mervyn King, former governor of the Bank of England, and economist John Kay. Predicting anything seems dangerous today, given how many forecasts have gone wrong in recent years — and how foggy the future now seems.
No wonder. For many years individual investors expected a steady rate of return on their portfolio, and retirees were conditioned to assume they could draw down their accumulated funds in a predictable way. But stock markets have swung wildly since early 2020, and growth — and inflation — expectations constantly defied predictions.
Even the smart money has been wrongfooted. Take Bridgewater, one of the largest — and best performing — funds in the world. It examined what it got wrong about its recent projections, and admitted its assumptions about growth and equity prices had misfired. “If we look at how things have transpired [for the US economy] we haven’t yet seen the downturn we expected,” it observed.
Similar sentiments are bubbling inside other institutions. So too at central banks. “No one knows with any certainty where the economy will be a year or more from now,” US Federal Reserve chair Jay Powell admitted late last year, after it became clear that Fed forecasts on inflation were wildly wrong.
So is there any way to handle this (other than giving up on forecasts altogether or resorting to astrology)? I would argue we can start by pondering the tools that many investors, financiers and central bankers have used in recent years to navigate the world — and modify them.
The problem is tunnel vision. During the second half of the 20th century — or when many FT readers grew up — the financial and corporate world used the amazing advances in computing power to develop distinctive intellectual tools to analyse the past and present, such as economic models, corporate balance sheets and Big Data analysis.
These three tools are fantastically useful: as Peter Bernstein noted in his 20th century classic tome Against The Gods, they transformed how modern societies handle risks. However, they all suffer from a vulnerability: they are only as good as the inputs. More specifically, since no model, balance sheet or Big Data set can possibly capture everything happening, fields of information are inevitably left out.
If the material that is excluded is stable in nature and/or small in impact, these omissions might not matter. Often that is the case; if you are predicting future gross domestic product, it does not matter if your economic model ignores the colour of a population’s hair. But sometimes the material excluded from the models is changing in a way that matters enormously. And that is the situation we face today: issues which were not factored into the models before, such as climate change, medical risks, technological change or war, are becoming very important.
That does not mean that we should toss out these intellectual tools. Far from it; balance sheets and models are vital. But we need to think about the wider cultural, physical and technological context — and what we have ignored.
Or to use an analogy I developed in a recent book, if you look at models and balance sheets without studying the inputs — and exclusions — you are acting like someone walking through a dark wood with a compass, who only stares at the dial. Even if the compass is technologically brilliant and shows the macro direction, if you only stare at the dial you will walk into a tree.
Instead, the better way to navigate is to look at that compass dial — and use lateral vision to look around at the wider world. Or as Joseph Stiglitz, the Nobel-prize winning economist says, the problem with “seemingly complex and sophisticated econometric modelling [is that it] often fails to take into account common sense and observable reality”.
So if investors want to avoid walking into a metaphorical tree today, I would suggest they should think about at least five issues that have often been excluded from models and balance sheets before: tech change, the environment, war, health and the political culture of business. All now matter.
At first glance, tech is a blindingly obvious theme to put into economic models, given its central role in the 21st century. After all, anyone holding Big Tech stocks has enjoyed an astonishingly good ride in the past decade. And the current buzz about artificial intelligence is sparking another boom in the valuation of AI-linked stocks, such as OpenAI and Anthropic — and chipmakers such as Nvidia.
But while financiers and economists track tech companies closely, what is sometimes ignored is how digitisation is changing consumer and corporate culture in some subtle but powerful ways that make models of the past less relevant as guides to the future.
Consider, as a timely example, what happened this year with Silicon Valley Bank. Regulators have long known that the digitisation of finance has changed how money moves. But until SVB imploded, regulators at the Federal Reserve and Federal Deposit Insurance Corporation presumed that if a regional lender ever ran into trouble, a bank run would occur slowly enough to let regulators craft a policy response over a weekend. International banking rules only require banks to hold enough assets to survive losing 5 per cent of their deposits each day for a month.
But when SVB ran into trouble it lost $42bn of its $200bn funds in a few hours, and more than $100bn the next day, because its customers were a highly concentrated tech-savvy “tribe”. In retrospect, this should have been obvious. But the financial models of bank risks do not take account of the cultural patterns of a bank’s depositors. “We need to change how we look at this,” admits Michael Barr, deputy Fed chair in charge of financial supervision.
This should make us all think about other business fields where customers are no longer “sticky”, ie loyal. We also need to consider how digitisation is changing patterns of trust: today’s consumers, voters and employees are more likely to get information from their online peer group than hierarchical authority figures, creating horizontal patterns of so-called “distributed trust”, to use a phrase coined by sociologist Rachel Botsman. We should also consider how cell phones are changing C-suite behaviour by creating once-unimaginable levels of transparency, as with the #metoo scandals. Meanwhile, rising numbers of economic activities are no longer mediated with money, since consumers (or companies) are getting “free” internet services in exchange for handing over data.
Until a decade ago, the environment was another topic often excluded from models and corporate reports, or at best treated as a footnote; the natural resources consumed by businesses, such as water, were not priced and companies’ impact on the environment was overlooked.
This is now changing: around 1,500 companies with $217tn of assets have adopted metrics such as the Taskforce for Climate-Related Financial Disclosure (which tracks emissions), and 10,000 use the Global Reporting Initiative standards on sustainability. The IMF, World Bank, and central banks are incorporating these approaches too.
This is welcome, albeit belated. However, our models still fail to capture some aspects of climate change, not just in terms of tangible weather risks, but the policy response and associated green innovation. Consider the US’s Inflation Reduction Act. Until last summer, it seemed hard to imagine Washington implementing large-scale green policies anytime soon; so much so, that when the idea of the Act emerged last summer, European officials paid scant attention (and were subsequently wrongfooted when the IRA excluded European firms).
Congress confounded cynics by embracing the bill. This may not be enough to avert climate change. But the Act has turbocharged green manufacturing and investment. “Since @POTUS took office, private companies have announced over $480bn in manufacturing and clean energy investments & the Admin has awarded over $220bn in infrastructure funding,” Heather Boushey, an economic adviser to the White House, tweeted this week. That was just not factored into economists’ models two years ago.
Or consider Europe. When Russia invaded Ukraine in February 2022, economic models suggested the loss of cheap Russian gas would devastate the European economy. This did not occur, partly because of warmer than expected weather, and imports of liquid natural gas. But we also saw an explosion in the deployment of renewable energy and rising energy efficiency that was not previously anticipated. Hooray.
Until a few years ago, when attendees at World Economic Forum’s annual meeting at Davos were asked to rank risks, they rarely put violent conflict in the top 10. Instead, financial crises, debt, cyber security and environment dominated their worries. No longer: the latest WEF report, released in January, after Russia’s brutal invasion of Ukraine, cites “geoeconomic confrontation” and an “erosion of social cohesion” on that list. “We have seen a return of “older” risks, which few of this generation’s business leaders and public policymakers have experienced,” the WEF noted, citing issues such as “nuclear warfare” and “geopolitical confrontations” as some of these new (old) threats.
This is forcing investors to confront horrifying questions: could China invade Taiwan? Might the US fight Iran? Where will the West procure semiconductors if Taiwan is lost? Who will supply rare earth minerals? Could underwater sea cables that supply internet links be cut? You cannot model this. But investors need to think about these dangers — and ponder whether surging defence investment could raise growth (which is good) or inflation (which is bad), or unleash innovation.
In the past, after all, defence research created the internet (among many other military innovations.) Today’s conflict in Ukraine could shape the future of drones and satellite links, for example.
Another oft-overlooked factor is the culture of the political economy and society’s expectations around business. The second half of the 20th century was not just an era when economic models and balance sheets flourished; an entire generation in the West was also imbued with the “Friedman doctrine”, named after free-market economist Milton Friedman who penned an (in)famous 1970 essay arguing that the top “social responsibility of business is to increase its profits”.
This shaped assumptions of investors, many of whom assume that government intervention in “free” markets is a bad idea. But since the Great Financial Crisis of 2008, there has been a stealthy paradigm shift in the West, as more state intervention has crept in, first in finance (to stem the GFC), then in money markets (with quantitative easing), then in healthcare systems and supply chains (during the Covid-19 pandemic) — and most recently in the energy sector and strategic industries such as chips (as a result of war.)
Industrial policy is no longer a dirty word; a more collaborative mentality has set in. One expression of this is an explosion in companies adhering to sustainability metrics; another is the rising use of patriotic language in sectors such as tech, and a drive for more domestic production. And the more geopolitical conflict rears its head, the more pronounced this zeitgeist shift is likely to become. This change is itself hard to model, but it matters, since it means regulatory controls in finance, tech and healthcare could be different from the past.
Before early 2020, health risks were also excluded in most economic models and corporate reports, apart from healthcare groups. That changed when the pandemic hit — and today no government (or economist) would dare say they are ignoring future infectious disease risks.
That is progress. And it could create rich investment opportunities in the future around, say, new vaccines or telemedicine. But some aspects of public health remain overlooked in models.
Mental health and addiction issues, for example, can impact employee productivity and growth, but are often ignored. And until recently there was little focus on demographics — even though it has long been clear that China’s one-child policy could cause its population to shrink, even as the US enjoys a strikingly young demographic profile, compared with other Western nations. Established economic projections could misfire (though if robots replace human work this may complicate things even more).
These five starting points are not exhaustive: topics such as populism, inequality and cyber crime are also important pieces of “context”. And such issues are not necessarily a reason for pessimism per se.
Yes, war is dangerous and destructive. So is climate change. But innovations in tech, healthcare and energy offer grounds for optimism. The surprises that are hitting us now, in other words, are both bad and good — even if the former appear more urgent and significant right now.
But the key point is this: whether pessimists or optimists, we must widen our lens — and imagination — and see the context of our assumptions. Looking around the metaphorical compass is more critical than ever now; no investor wants to walk into a tree.
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