The Federal Reserve has a new principal called Ben Bernanke, who took over from Alan Greenspan who ruled the roost for 20 years until he retired with a golden watch and a pat on the back last year. Ordinarily this change would pass unnoticed except by City and Wall Street geeks, but there could be some important knock on effects, even for UK investors.
The role of the Federal Reserve is to look after the banking and monetary system to help the US achieve full employment with low inflation and low interest rates. This is a pretty tough task but, over the last 20 years, under Mr Greenspan, exam results have been good and the US rose up the league tables of economic stability. Wall Street also benefited from this, enjoying a very long period of unprecedented economic growth and prosperity.
There were some critics outside the school gates though. Mr Greenspan achieved his great end of year report by helping out some of his less gifted pupils, which his critics referred to as creating “moral hazard”. This is a bit like a school teacher boosting a child’s marks because the child has some sort of excuse. But doing this is not helping in the long run, it is rewarding and encouraging poor study habits and creating “moral hazard”. In the financial world the moral hazard took the form of bailing out banks that had made imprudent and wrong bets on the markets or borrowers.
For instance, Citibank lent too much money in the 1980’s to countries unable to repay their debts, saying famously that “countries don’t go bust”. Wrong. Citibank lost billions and under different circumstances the organisation would have disappeared but the Federal Reserve, under Mr Greenspan, stepped in and Citibank were rescued by being given super cheap loans to tide them over. Thus Citibank went unpunished for its poor lending habits and sending the wrong signal to all the big US banks.
In 1998 a large hedge fund, called LTCM, was on the verge of bankruptcy due some huge bets that went wrong. A failure of this size would have hurt all the banks that had supported and benefited from lending to LTCM. Mr Greenspan stepped in and organised its bail out, protecting the banks from their bad lending habits and building moral hazard.
Mr Greenspan helped out the financial world’s bad habits so often that many bankers began to see the financial markets as a one way bet. They even coined the idea of the “Greenspan put”. This meant that you can always invest knowing that in the last resort you will be helped out by the Federal Reserve if things go wrong. Arguably, the moral hazard created over the last 20 years has led to the profusion of hedge funds that invest in today’s markets using borrowed money. These hedge funds can generate huge profits when things go right, but when things go wrong, they really go wrong.
Mr Bernanke seems to be a bit stricter than Mr Greenspan. Those that formed bad habits over the last 20 years are having their wrists slapped at the moment. Some may be expelled and disappear altogether. Over the last few months some speculative investors, notably the US bank Bear Stearns, have suffered large losses buying junk bonds. There had been some hope that the Federal Reserve might step in last week to cut interest rates and help ease the pain of these speculators. But pointedly this did not happen. Mr Bernanke seems to be giving these investors some hard love by letting them suffer the consequences of their own actions. The Federal Reserve has gone back to basics, a sort of 3 ”R”s in line with its purpose – Rates, pRices and woRk!
What does this mean for the UK investor? Undoubtedly, there will be more moans from Wall Street and the City as they unlearn the bad habits of the past. There may be greater volatility in some the more speculative investments that investors hold, but for the more long term investors the present environment presents an opportunity to gradually build up some sensible investments at home and abroad for the long term as the short term speculators are chased out. As we say at 7IM, it is not timing the market, it is time in the market that counts, coupled with a spreading of risks across a variety of assets.
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And finally – apparently in Japan they have invented furniture that changes colour. An interactive table and chairs set picks up the colour of whatever is placed on the table top and changes the colour of the stools near the table to match it. The stools also change colour depending on your weight – heavier people get dark colours. If we had this at home my furniture would undoubtedly be pure white when my wife sits on it, quite a lot darker for me!
Have a good week,
Peter Sleep
Senior Investment Manager