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2008 Year End Situation and Methodology Update - This will now be a monthly feature.
October is usually the month when we review the latest "Global Financial Stability Report" and "World Economic Outlook" published by the International Monetary Fund, and compare them to our own scenarios. This year, however, events have evolved so rapidly that these publications are already a bit out of date. For that reason, our summary of their contents will be brief. The GFSR notes that "confidence in global financial institutions and markets has been badly shaken", due to the "continuing decline in the U.S. housing market and wider economic slowdown [that] is contributing to new loan deterioration - delinquencies on prime mortgages and commercial real estate as well as corporate and consumer loans are increasing. With default rates yet to peak and the recent heightened market distress, declared losses on U.S. loans and securitized assets are likely to increase further to about $1.4 trillion, significantly higher than previous estimates." The resulting "deleveraging in the banking sector will take place along multiple dimensions, requiring asset sales, slower new asset growth, and radical changes to banks' business models as many previous sources of revenue have nearly disappeared...A similar deleveraging process is underway for many non-banks, such as hedge funds, where the ability to use margin financing and private repurchase markets to take leveraged positions has been severely curtailed." The October GFSR concludes that "internationally coherent and decisive policy measures will be required to restore confidence in the global financial system. Failure to do so could usher in a period in which the ongoing deleveraging process becomes increasingly disorderly and costly for the real economy."
The October WEO is equally bleak in its forecast. "After years of strong growth, the world economy is decelerating quickly. Global activity is being buffeted by an extraordinary financial shock and by still high energy and other commodity prices...In hindsight, lax macroeconomic and regulatory policies may have allowed the global economy to exceed its 'speed limit' and may have contributed to a buildup of imbalances across financial, housing, and commodity markets. At the same time, market flaws, together with policy shortcomings, have prevented equilibrating mechanisms from operating effectively and allowed market stresses to build." Looking forward, the IMF's baseline forecast still projects positive, if much reduced real growth at the global level, driven by continuing growth in China and other emerging markets and stronger fiscal stimulus by developed country governments. However, it also stresses that "there are substantial downside risks to this baseline forecast. The principal risk revolves around two related financial concerns: that financial stress could remain very high and that credit constraints from deleveraging that could be deeper and more protracted than envisaged in the baseline. In addition, the U.S. housing market deterioration could be deeper and more prolonged than forecast, while European housing markets could weaken more broadly. Inflation risks to growth are no more balanced because commodity prices have retreated as the global economy slows. At the same time, potential disruptions to capital flows and the risks of rising protectionism represent additional risks to the recovery."
For better or worse, recent developments are consistent with the scenarios we have been using for the past few years, the most likely of which was the significant and somewhat chaotic downturn we are now experiencing, now that U.S. consumers have hit the point of maximum leverage and begun to reverse their spending and borrowing. In our view, the key question has been how events would evolve once we had reached this point. In the past, we have described two alternate paths (or "attractors", in the language of complex adaptive systems theory): one characterized by a high degree of cooperation and the other by a high degree of conflict. We have further described our belief that the path the world ends up following will depend on the actions of three key groups: the American middle class, Chinese peasants, and Iranian youth. Let us look at each of these. [For complete article, please link to October 2008 ]
Successful investing requires us to make sense of situations that are often characterized by rapid change, information overload, and time pressure to make high stakes decisions. Even passive investors face this challenge, to the extent that they need to identify and limit their exposure to substantially overvalued asset classes, with their attendant potential for large losses. In our conception of this challenge, sensemaking is a circular process, characterized by multiple feedback loops, that is comprised of three stages:
The circularity and complexity of this process manifests itself in many ways. Consider the first stage - the allocation of our scarce attention. To a great extent, this takes place outside of our conscious control, guided by our existing mental model (developed in stage 2) about the way the world works - the key variables to which we must pay attention, their normal range of values, and how they interact with each other to produce outcomes of interest (e.g., returns on our portfolio). We also have a natural tendency (which was no doubt useful eons ago when our ancestors lived on the East African plain) to attend to variables characterized by fast and/or large changes. To the extent that we are conscious of decisions regarding how we allocate our scarce attention, we are most often trying to check on how our previous forecasts matched up with actual results, rather than how well the indicators we used actually correlated with the eventual outcomes we were trying to forecast. However, when the gap between our forecasted outcomes and the actual result grows too wide, it can trigger a reexamination of our basic mental model of the situation. We also have a well-documented tendency to pay attention to information that others are also focusing on, regardless of its reliability and diagnostic value (i.e., its ability to help us determine which explanation or forecast is most likely to be accurate). To a greater extent than most of us acknowledge, the allocation of our scarce attention is socially driven. [For complete article please link to "May 2008"]