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Robert Talbut: Regulation has shifted rather than reduced risk

by Robert Talbut on Jun 25, 2014 at 13:26

Robert Talbut: Regulation has shifted rather than reduced risk

The impact of the regulatory policy since the financial crisis has been to remove risk from a location where it can be closely monitored and to disperse it throughout the economy, leading overall to a reduced risk appetite.

The focus of attention on the banks has centred on their ability and willingness to lend to small companies whereas the restrictions upon their capacity to provide liquidity to financial markets has been overlooked. The combination of reduced market liquidity (through changes in capital requirements), the herding of investors towards a clear but fragile consensus over future prospects (in large part through policymakers actions) means that riskiness of markets is far greater than might be appreciated.

I would argue that with significantly reduced depth to markets and high congestion of investor positions, the next period of market disruption will be characterised by ‘gaps’ in trading as markets shift 5, 10 or even 20%  in order to reflect new fundamental views. Overall we’re now creating a system with an ‘exit’ which is too narrow to allow investors to use when the next shock arrives.

In such a ‘gapping’ market I’d expect all stocks to fall sharply, even those with assumed higher liquidity. The combination of more volatile and less liquid portfolios with reduced opportunities to outperform is not a great combination for investors but is the consequence of the regulatory approach since the crisis.

The likelihood of more volatile financial markets with more ‘gaps’ in trading is highly likely to act to restrain consumer and corporate confidence leading to a weakening in ‘animal spirits’ and therefore economic activity. This is an example where reducing the level of risk in one part of the financial system is leading to greater risks of volatility in other parts of the system. It should be apparent that in an increasingly interconnected economy the result is the shifting of risk rather than the reduction.

Given the well documented fact that most employment growth and innovation takes place in smaller entities the consequences for growth and general dynamism in the economy are obvious and will become apparent over time. Essentially we will witness a changing corporate structure in developed markets in favour of larger incumbent companies who are better able to cope with increased volatility and risk as a consequence of materially altering the funding mechanisms available to companies.

The choice of regulators appears to be that we wish for fewer big shocks (in banks) but at the expense of lower overall rates of growth and more widespread volatility and uncertainty. While this might be a reasonable public policy outcome I think it advisable that we all understand the consequences of these moves and accept that the lower risk appetite has negative consequences.

One of the biggest conundrums underlying the authority’s intentions is that to return to a ‘normalised’ set of policy settings we require a ‘normal’ economy. The circumstances where we could all identify a normal economy appear very far off.

Robert Talbut is chief investment officer at Royal London Asset Management

1 comment so far. Why not have your say?

Gavin Palmer

Jun 27, 2014 at 21:01

With a slight increase in Interest rates back to normal level relative to inflation ie RPI+2%, Bonds will have to compensate and thus a fall in capital value to raise the yield. How much depends on how high the insistant demand is still caused by regulation of Pension Funds to have to buy long dated bonds and thus skew the pricing - afterall its supply and demand that sets the price not fundamentals in a rigged market.

With a normalised yield to allow for inflation on equities and bonds, govt funding will be more reliant on printing money to balance the borrowing books.

However such is the boost that low interest rates give to the incomes of mortgage paying homeowners and the chance of tipping businesses into an abyss of inability to pay means politically putting rates to 3% would remove too much from the homeowners economic input and into banks pockets I guess they fear.

So the political fix of "put it off to tomorrow" or onto another government to fix the issue/cop the blame until the interest and govt borrowing overwhelms the pension etc industry to finally fix it.

In that scenario either debt written off or yet more inflation is the solution and investing in the real assets of property, equites in pricing powered businesses and internet low capital requirements businesses is the norm as well as shortening the duration of bonds held. Who buys the rest well - its pass the parcel or advertise the bonds overseas and to Private investors is the normal solution.

Art, collectibles another inflation hedge and given the worldwide printing of money whether its pound sterling or monopoly money if a man has more cash they pay more 'or their wife does' on these items and the market reflects that.

So in terms of where to go - Bonds, equities/part of a business, money markets, commodities, property there is the standard order in tough times and inflationary times the same as in 1995 and back to the 1600s. Just this time the Govt authorities have killed/stifled canaries 'gold', long bond yield (UK), obfuscicated data RPI, M measures disappeared, selling gold central bank stores, QE, and buying their own treasury/bond bills (US UK. .)

So the technical side of investing is out of kilter with the fundamental. With the power of money printing held by the BofE and the Fed the choice is political regarding the timing.

Sadly bond traders dont have the same power over the government to correct bad behaviour that they once had epitomised by the ex Chancellor of the Exchequer who wanted to come back in another life as a bond trader because "then he would have real power!"

So its 1 year to a General election in the UK, US is at the end of 2016. With the governing partys preference to dump the issue on the rival sides intray to take the blame.

The tipping point hmmm one has to vote with the central bank.

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