Crisis Management

July 5, 2005

Dear Investor:

A recent New York Times article has cited a prediction of a 75% chance of a financial crisis in the next five years. This type of warning is akin to the recent 60% prediction that a WMD will be used by terrorists in the next ten years: probably true and of very little help.

If you could tell when or what the crisis might be, it would offer something. But a 75% chance of an unspecified disaster at an unspecified time—like most things full of sound and fury—signifies nothing.

The prediction likely understates the probability because financial crises are common, cyclical, normal and inevitable. We’ve had many worldwide financial crises in the past decade: the Asian currency collapse, Long Term Capital Management, the Internet debacle, the worst bear market since the Great Depression, Enron et al. This is not an exhaustive list.

There’s no doubt we will encounter another crisis in the coming years. But financial crises are like bike messengers in Manhattan—they come from unforeseen directions. Without knowing the type or timing, protecting yourself against a crisis is tricky. The best protection is a well-diversified, balanced portfolio, adjusted to the client’s preferences, time horizons and risk tolerance.

Such a portfolio is most likely to withstand any crisis relative to that particular client because it takes the worst-case scenario for that client into account. A portfolio for a retired, older client, for example, with 30% equities and 70% bonds, is unlikely to be derailed even by an equity collapse. In addition, the equity position, though small, will provide an effective hedge against inflation, especially if combined with inflation protected bonds. At the other end of the spectrum, a 100% equity portfolio designed for a young, working client is exposed to equity conditions in any given short term period, but is likely over many decades to provide an 8%-10% annualized return and a real return over the inflation rate of 5%-6%. Both clients are reasonably protected against disaster, not because their portfolios incorporate risky, complex hedging strategies or foreknowledge of the next crisis, but because they have been tailored with diversification, asset allocation and common sense.

The press is always alarmist. But this recent New York Times piece, cloaked behind a mantle of respectable admonition, is the sort of yellow journalism to make the tabloids proud. It trots forth a whole list of problems with economic ignorance.

Since successful investment is predicated on separating the red herrings from the real problems, it’s time to take on two of these issues and assess their validity.

Chinese Purchase of Treasury Bonds: Though the press (and the NYT specifically) portrays this as a problem, it’s not—at least in the sense that the Chinese are the purchasers. The populist xenophobia that surrounds this issue is remarkable for its lack of economic aptitude. That the Chinese are lending us money does not make us any more dependent on the Chinese than does it make Donald Trump dependent on his creditors. As any scholar of financial history knows, it’s very much the reverse: a creditor is utterly beholden to its borrower, on whom it has to depend for payment. To the extent that China wishes to get paid, it must protect our economy, which has become its golden egg. This type of dependence breeds better, not worse, global security.

In addition, a borrower (once the terms of the loan are determined) should not care who its lender is. It must repay the debt, be the lender Chinese, Croatian, or Californian. Similarly, a homeowner does not care about its mortgage lender, only its mortgage terms. But if that homeowner buys a bond (becomes a lender), then it definitely should care to whom it writes the check. As readers of our letters know, we do feel that the Chinese purchase of bonds is helping foment our real estate bubble by keeping rates artificially low. But this is a question of currency policy, not the nationality of the bondholder.

Growing Deficits: This is not a red herring, but a real problem. The press is right to send up the warning flare. To the extent that debt obligations grow beyond the reach of GDP, interest rates will rise rapidly, undermining growth and devastating long term lenders (the Chinese, not us, should be worried!). But the press pays little attention to the fact that reflation of the economy has thus far worked: GDP growth is strong, unemployment is at 5.1%. From Alexander Hamilton to John Maynard Keynes, it has been known that governments can (and should) run deficits to spur growth. The question becomes whether such increased growth can eventually pay off the rising debt load. If it becomes self-propagating, yes. If not, no.

Despite the doomsayers who predicted otherwise, signs point to yes: payroll growth is strong, tax revenues are exceeding budget estimates and small business creation is healthy. On the other hand, the government is spending like a drunken sailor on a year-long bender. It’s right to spend madly to prime the pump, but wrong to spend madly otherwise. Interest rates probably will rise substantially and we’ve built this expectation into our strategy, keeping bond duration very low across client accounts.

We wish we could tell you we had a miraculous hedging strategy that would protect you against any financial crisis, but we can’t. If someone tells you they have such a magic bullet, run the other way. No such thing exists. A “risk-free” strategy is a fantasy. Some high-profile managers (i.e Long Term Capital Management) have thought they found such a miracle, only to realize too late that there really is no free lunch. On the other hand, smart asset allocation and diversification, along with a discerning eye to separate real concerns from red herrings, provide the best protection against crisis—from any direction.