Wegelin & Co - Investment commentary 272 - Too Big Not To Fail

8/8/2019 Wegelin & Co - Investment commentary 272 - Too Big Not To Fail

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Investment Commentary No. 272 August 23, 2010

Too big not to fail

1. Zero returnsThose who possess assets, or indeed live fromthem, assume that they will generate a return.Not every day, admittedly, or even every year.

But at least in the long term, on average, and oncondition that everything has not been bet, un-wisely, on a single asset or category of assets.Investors our clients live from and with thisquasi-axiom of positive returns, and so do we,who advise them and act with them in thesematters. And all the complex portfolio optimisa-tions of the insurance companies and the pen-sion funds are based on this single quasi-axiom:on the expected average return five, six ormore percent for stocks, three or four percentfor fixed-interest investments, one or two per-

cent for short-term money rest all the strategicand tactical decisions and guidelines regarded bythe responsible bodies and the supervisory au-thorities as a more or less sacred mantra. Theyare sanctified under the rubric of economicfundamentals. The assumptions for averagereturns are thus not a quasi-axiom, but a real one,not subject to challenge.

Far be it from us to call this economic funda-mental into question. Basically, we believe in itourselves (what else should we believe in?). Itsjust that real-time events currently and, sadly,

currently here means for a considerable timenow tell a different story. Theres little ornothing to be made from assets. Returns havepractically reached zero, and, regrettably, thisapplies to a good many of the relevant assetcategories.

Lets start with money-market investments; withcall and fixed deposits, money-market funds, andthe like. In Swiss francs, theres no return undersix months, unless the selected investment con-tains some sort of additional risk (LehmanBrothers ). Things are not really any betterwith the investment currencies, the euro and theUS dollar, and certainly not for the yen.

Anyone wanting to achieve a return of at leastone percent from a fixed-interest investment inSwiss francs must opt for a maturity of almostfive years, if he wishes to entrust his funds to areasonably reliable debtor. The yield on a ten-year investment in US T-bills is currently 2.6percent; the yield on eurobonds is at a similar

level, and, once again, theres not much to behad from the yen. Long-term bond investmentsare, however, exposed to a significant interest-rate risk. Roughly speaking, the potential fall inprice if the interest rate rises by one percent isabout equivalent to the weighted maturity of thebond. So far, it has been worthwhile acceptingthis risk, as interest rates have fallen furtherfrom an already low level. The rises in the priceof bonds this produced have also been responsi-ble for some of the returns generated on mixedportfolios. This agreeable state of affairs is now,however, gradually coming to an end, as long-

and even longer-term (30-year T-bills) invest-ments approach zero yields. The consequencesof interest-rate risk are becoming increasinglyasymmetrical.

And what about stocks, of which it is said thatthey should reward investors with a hefty eq-uity risk premium? The picture could hardly bemore sombre. Those who with their unbelievablyingenious tactical over- and underweighting haveearned nothing, but at least made no mistakes that is, those who have simply held stocks intheir portfolio on a diversified basis will have

to go back ten or even, depending on the region,up to eleven (USA) or twenty (Japan) years tosee a positive return. And this, nota bene, in-cluding reinvested dividends. The figure belowshows clearly how stocks have been markingtime. Given that very many deliberate invest-ment decisions are made pro-cyclically, it ismore than likely to be the case that a very largenumber of investors have been waiting a verylong time for an appropriate return on theircapital.


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Investment Commentary No. 272 Page 2

Stocks: the long wait

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Jan 99 Jan 00 Jan 01 Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10

USA

Germany

Indexed (July 2010)

Japan

Switzerland

Source: Bloomberg; Wegelin analysisNote: Regional total-return indices (i.e. with reinvesteddividends) in local currencies; S&P 500 for the USA, SPI forSwitzerland, DAX for Germany

With returns like these, it is little wonder thatpeople are increasingly wondering what thepoint of it all is. A realistic perspective on re-turns offers cold comfort. It is the case that infla-tion has also been low in recent years, so thatholding on to the assets has at least not involvedany significant loss of purchasing power. But nopension fund is kept going by zero returns, andnor is any satisfactory cash-flow generated froman individual pensioners capital. Look at it howyou like: those dependent on returns from theirassets have been holding a bad hand for somewhile.

2. Perplexity as a phenomenonAt times when axioms and quasi-axioms comeunder discussion, when fundamental questionsare being posed and when so many situationshave never been like this before, its smallwonder that those most easily observable indica-tors of the public mood, the stock exchanges, arewallowing around like a ship that has lost bothkeel and rudder, and whose sails are in shreds.The lack of direction on the stock markets overrecent months has been almost unbearable for

many market players, and the commentatorshave excelled themselves with overinterpreta-tions of events of little or no significance.

The most recent example of this is provided bythe apparently so disappointing economic statis-tics from the USA. There is undoubtedly a re-markable amount about the country that invitesnegative reporting: the continuing high rate ofunemployment for instance, the failure to re-structure the real estate market, or the exorbi-tant rise in the national debt. We shall comeback to these matters in this Investment Com-

mentary, but they have all been known about fora good while now. But if the rate of accelerationof a couple of indicators, such as the quarterlychange in GDP, slackens off a bit after the rapid

upswing out of the recession of 2008/2009 (whichwas entirely predictable to any level-headedobserver), then the suggestion that this presagesdescent into another recession can only be re-

garded as evidence of a thoroughly over-excitedstate of nerves. Double dip has been the newbuzzword in recent weeks. Over-excitement is apoor counsellor: those who believe they can seea change of trend here will all too often to bedeceived by natural fluctuations and the oscilla-tion of data.

No, there are no key economic question marks,either in the USA or in Europe. Those whobased their economic forecasts on an indiscrimi-nate extrapolation of the rapid increase in indus-trial inventory (in the wake of the abrupt

reduction in inventory caused by the extensivecollapse of global trade as a consequence of thefinancial crisis in the previous year) were quitesimply wrong. Those who based their profit fore-casts directly on company figures fuelled by therebound were simply too euphoric. The lazy L,the wearisome economic recovery that we fearedlay ahead for the next couple of years, seemsincreasingly likely to be the outlook for the west-ern industrial nations including, incidentally,Germany, and its apparently miraculous exports;here too, there is no call for the over-interpretation of a specific situation. The overallEuropean situation is characterised by a muchmore sluggish track. With regard to economicissues, there is no real justification either forperplexity or for the enormous mood swings onthe stock exchanges.

The problem arises with structural issues. Here,perplexity is more than justified. Lets begin withthe banking system, as it presents itself in thewake of the financial crisis. How healthy is itreally? Nominally, it doesnt look too bad earnings, and particularly those of the institu-tions hard-hit by the crisis, have improvedsharply. Balance sheets, for example those ofUBS or Citigroup, have been seriously reduced.And the equity situation has improved corre-spondingly. So far, so good. But is the bankingsystem in the western industrial nations actuallyfulfilling its economic function? Strangely, at atime of record availability of cheap liquidityfrom the central banks (hence the low moneymarket rates in all the relevant currencies) thereis almost no credit business going on. This meansthat the banks have remained almost inactive intheir function as conveyor belts between the

central banks and the real economy. Or, to put itmore plainly, since the financial crisis the bankshave remained in a dysfunctional state.


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The figure below makes the situation abundantlyplain. The money supply M3 in the USA, whichis no longer calculated by the Fed (why not?) butis still tracked by intelligent people, continues to

plummet, while the Feds excess reserves remainat the highest level.

Misallocated money

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Jan 08 Apr 08 Jul 08 Oct 08 Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 Apr 10 Jul 10

11,700

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Commercial bank reserves with the Fed

(left-hand scale)

Money supply M3

(right-hand scale)

Source: Federal Reserve, shadowstats.comNote: Figures in USD billion; M3 = Cash + savings + timedeposits

Of course, blame can be laid at the door of thereal economy, which is obviously generating toolittle demand for credit: You can lead the horseto water, but you cant make it drink. The lackof enthusiasm for investment is probably themirror-image of the lack of risk appetite on thebanking side. With interest rates very low nomi-nally, and possibly negative in real terms, suchbehaviour on both sides is extremely strange, ifnot indeed off-putting. Something must be radi-cally wrong somewhere: otherwise an investmentand credit boom would be in full swing!

Low interest rates, record liquidity supplies,quantitative easing (which can be equatedwith the direct supply of capital to the system bythe central banks), a farewell to the concept ofan exit strategy (i.e. to an end to quantitativeeasing): according to current economic theorywe should long have been feeling inflationarypressure. Hence the perplexity of the monetaristCassandras: inflation has fallen to an all-timelow on both sides of the Atlantic; there is no signof any constraint on the supply of goods, onaccount of the productivity gains both in theemerging markets and in the domestic econo-mies. It almost looks as if J. K. Galbraith, thatveteran Keynesian, was right after all. He re-cently utterly dismissed any warnings about thenegative impact of the extremely stimulatingmonetary and fiscal policy (The Economist,12.8.2010, p. 60). By way of reminder: TARP,the American governments stimulation pro-

gramme, amounted to USD 700 billion. Further,for fiscal 2009, the ARRA (American Recoveryand Reinvestment Act of 2009) was created withUSD 800 billion. The Feds balance sheet was

expanded from USD 943 billion (2008) to USD2,368 billion (2010) for the purpose of buying updomestic debt. The European and Japanesetotals look little different.

However, and heres another source of perplex-ity, Keynesian economics throws up more ques-tion marks than anything else never mindabout success stories. For even if it really is thecase that an extremely stimulatory monetary andfiscal policy does no damage with regard to infla-tion, it has sadly also become clear in the mean-while that it doesnt actually do much goodeither. Unemployment in the USA seems stuckat the high level of 9.5 percent (including thoseworking part-time who would be happy to workfull-time, its almost 20 percent), the US real

estate market has been at best stabilised, and therallying cry of Yes, we can! now generates atbest a weary shrug of the shoulders. Despiterecord low interest rates, average Americans aresaving, while the state piles deficit on deficit.Having been close to zero for many years, thesavings rate for American households is now 6.2percent. The US governments debt has risen by28.4 percent since the end of 2008. Put differ-ently: one side provides stimulation as neverbefore, but on the other side, this stimulationobviously achieves little or nothing.

Perplexity over monetary policy too. By now,the extreme stimulation of the system by practi-cally all the relevant central banks has comeunder criticism not only from academic circles,but also from insiders, so to speak. The annualreport of the Bank for International Settlements(BIS) devotes a whole chapter to the potentialnegative impact of the low-interest-rate policy(BIS 80th Annual Report, Basle, June 2010, p.36ff). It discusses microeconomic misallocationsby companies, as well as global distortions; thefear is expressed that the increasingly desperatesearch for returns will result in dangerous risk-taking by investors, and theres more in a similarvein. However, not one of the critics has everindicated where the right or at least an appro-priate interest rate might lie when there ispractically no inflation, and the fear is rather ofdeflation. Criticism is cheap when theres noneed to comment on the alternatives and theirrelative advantages and disadvantages.

3. A lonely student in a sea of flamesPerplexity in the markets, in all the institutionsand at all levels: this cries out for some effort at

explanation. Pictures are sometimes worth athousand words if they are the right ones. Letstry. With the burning steppes and smoulderingtundra, with the Kremlin swathed in acrid


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smoke, and a strangely detached President look-ing on from afar, Russia offered a variety ofimpressive images on the theme of perplexity inthe face of overwhelming events. The most

striking image of all, though, was that of a volun-teer (whatever that may mean in Russia), ayoung student armed with a fire hose from whichcame only a trickle of water, and a shovel to beatout smouldering fires, facing a wall of fire not ahundred yards off. Only the outlines of his facewere visible, on account of the clouds of smoke,but they revealed perplexity, hopelessness, res-ignation and also grief. Its a shattering portrayalof helplessness in the face of the forcesunleashed by nature.

So, where are the parallels with the prevailing

perplexity in the economic and financial systems;how far does the metaphor work? Firstly, theconcept of a conflagration seems to us to beentirely appropriate. In Russia, the fire did notstart in one place only; numberless fires brokeout across vast areas of the country. This hap-pened because the structural preconditions werein place after weeks of heatwave and continu-ing drought, the land itself was dry as tinder.Every individual fire no doubt had its own spe-cific cause. In the aggregate of a conflagration,however, these are really of no further interest,any more than the hopeless individual efforts tocontain the fires all of them futile, given thescale of the overall problem. There are situationsthat are simply no longer manageable, even fornuclear powers. Neither the dismissal of regionalgovernors, nor the deployment of vast numbersof volunteers, nor the mobilisation of all the firebrigades and fire-fighting helicopters, is any helpwhen the heat becomes more unbearable day byday and there seems no end to the drought. Tin-der remains tinder. What an unbearable idea foran authoritarian country: ultimately, and liter-ally, to be dependent on the heavens above or

the rain falling from them for relief from disas-ter.

Tinder remains tinder: Here is the heart of ourchosen image. In the crisis of 2008/2009, thefinancial system of the Western nations was firsthit by a conflagration. This was concentrated onthe highly exposed, enormously large, extremelycomplex and closely interlinked financial institu-tions, which had all, over the years, got rid oftheir fire-fighting reserves, as, given the longperiod without any real danger of fire, they hadcome to regard them as mere ballast. What first

appeared to be a problem for one sector re-vealed itself in the wake of the crisis as an over-whelming overall problem: the tinder of

excessive debt was fanned into flame by the heatof the continuing low-interest-rate policy.

Excessive debt: what does that mean from aneconomic perspective? That a particular de-

ployment of capital is not matched by any real,feasible project. Real, in the sense that, as far ascan reasonably be estimated, it should generatea positive cash-flow that can be used to cover thecost of both interest and principal. In the micro-economic context of a company, excessive debtmeans that it is overextended. If the accumu-lated liabilities are matched only by probablyworthless assets, the company is insolvent. Insol-vency is followed by restructuring, bankruptcy orthe finality of liquidation. In all three events,creditors are obliged to write off some of the

illusory value of their assets.In the build-up of excessive debt in the financialsystem it was above all real but increasingly un-feasible projects in the American real estatemarket that served as the substrate: state-sponsored homes for the economically chal-lenged. On this tinder devoid of intrinsic value,there grew up, over the years a gigantic structureof largely illusory character: business activityfuelled by lucrative commissions and based on asubstrate of little or no real value. All this activ-ity was endowed with dynamic stability by a

central bank renowned for its efforts to ensureso-called systemic security. Thus was created theunattractive situation at the start of the financialcrisis.

We know the results of the financial crisis. Therehas been restructuring which is to say, write-offs. The figure for the American commercialbanks is currently USD 1,200 billion. This repre-sents about half the estimated real damage. Withthe TARP programme and quantitative eas-ing, a large amount of risk simply found its wayinto the supposedly safe haven of the state.

Without the breathtakingly expensive support ofthe mortgage agencies Fannie Mae and FreddieMac by the US exchequer, far greater write-offswould have been needed. Tinder remains tinder;its just that now its state tinder.

In the meantime, with the crisis over Greece orthe euro the financial crisis of 2008/2009 hasnow spread to national budgets. Greece is a verysuitable case for classification as a real but un-feasible project. There seems little probabilitythat it will be able to service its high level of debtproperly from its own resources that is, to

manage interest payments, repayments and refi-nancing. Even after the so-called eurozone res-cue package, which was mainly to the benefit ofthe seriously exposed French and German


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banks, and the far greater emergency parachutefor the financially shaky countries of Portugal,Ireland, Spain and Italy, Greek bonds are stilltrading at prices that indicate the likelihood of

debt rescheduling. Now though for tinder re-mains tinder part of the tinder has shifted fromthe individual countries to the eurozone itself.

4. A battle of the giants or not?At the beginning of the euro-crisis, it lookedrather as if a battle for supremacy was in pro-gress between two battered giants, and that onegiant had a clear advantage. Day after day, arti-cles rained down from the USA, and the mediachannels it largely controls, laying into Europeand the eurozone. Without wishing to indulge inconspiracy theories, one thing is certain: theAmericans are world champions in the con-certed bashing of others. Between April and theend of June, the euro fell 10 percent against thedollar, and the European stock markets, particu-larly those of the countries most affected, sankinto a blood-red morass. All the European ef-forts to turn the situation around the uniquecascade of ever-larger rescue packages andemergency parachutes seemed without effect.

The situation of one of the giants improved, ifonly temporarily, when it became clear that theother giant was in at least as bad a way. It beganwith the threat of insolvency of some of the USstates; then followed evil tidings concerning theslow-down in the over-optimistically regardedupswing, while the continuing miserable state ofthe labour market combined with renewedanxieties in the real-estate sector to spread amood of hopelessness in sharp contrast to boththe scale of the stimulation measures and theeuphemisms that the Obama administrationcontinued to employ.

Since the middle of August, we have no longerbeen watching a battle for supremacy betweentwo giants. The financial markets the stockexchanges and the currency markets seem tohave come to terms with the fact that they aredealing with two equally battered entities. Asimilarly pessimistic estimate is evidenced by theexchange rate of the Swiss franc: since the be-ginning of June 2010, the US dollar has lost ahefty 11 percent against the franc and, after theeuros brief recovery to 1.38, it is now, as thisInvestment Commentary goes to press, back to1.32. The stock market wavers aimlessly hitherand yon; only the momentary German export

boom lightens the mood a little.In the wake of these unattractive developments,the Fed announced that it would, for the time

being, continue its policy of quantitative eas-ing for an unlimited period. The Europeancentral bank is maintaining a somewhat lowerprofile on this, but there is no question of any

end to the flood of liquidity, despite the positiveGerman figures, for the rest of the eurozonecontinues to battle with serious growth prob-lems. In Japan, the finance minister has invitedthe governor of the central bank to a frank andearnest discussion, as he blames the relativestrength of the yen for Japans being overtakenby its rival China. In other words, the three mainglobal reserve currencies are all simultaneouslyexperiencing the continuation, or repetition, ofwhat Japan has been trying to do for almost 20years now: to cudgel growth and stability intobeing through monetary policy.

This phenomenon, which affects the great partof the developed industrial nations, deservessomewhat closer analysis. We may begin by ob-serving that the policy obviously does not work,or, put more forcefully, is condemned to monu-mental failure. Japan provides the long-termempirical evidence, and Europe and the USAare well on their way into the same troubledwaters. Why?

5. Implicit uneaseBack to the image of the young Russian volun-teer facing the sea of flames. The problem is notthe presence or absence of water to extinguishthe fire. The problem is the incalculably largearea of land threatened by the fire; the excessiveamount of tinder that makes every attempt tocontain individual fires seem hopeless. We havedefined tinder as the excessive debt that wascreated in the developed nations through thefinancial crisis and its consequences.

But this perspective ultimately an accountingone may be too limited. The real problem isnot the shortfall, expressed in dollars, euros oryen. These are at most the visible symptoms of amuch more fundamental structural problem.This structural problem of developed social sys-tems lies in the fact that the numberless claimsand entitlements that characterise the institu-tions in these social systems old-age pensions,healthcare, redistribution are counterbalancedby ever fewer feasible real projects. Amongother things, this relates, particularly when wethink of Japan and Europe, to the inevitabledecline in the number of young people whocould carry out such real projects. The effects of

the demographic challenge on the existing socialsystems are half-way understood, but, unattrac-tive as they are to the current electorate, theyare having far too little impact on everyday poli-


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tics. The tinder of excessive debt is being builtup, slowly, year by year, layer on layer; themechanisms of democracy are not in a positionto master the asymmetry between short-term

political realism and the demands of long-termsustainability.

Going beyond the demographic problem, thedeveloped social systems, including the USAs,also seem to be generally overwhelmed by thetask of managing all the various claims and enti-tlements. For over 30 years now, the socio-political branch of sociology has been pointingout the defect immanent in democratic decision-making mechanisms: that the benefit derivedfrom lobbying for specific advantages far ex-ceeds the costs incurred for the tax-paying col-

lective. When state institutions further concealthese costs, through the possibility of taking onmore or less unlimited debt, simply handing thebill on to the next generation, and when it is alsopossible to keep the cost of interest on thesedebts artificially low, then there is a great dangerthat the result will be a practically irreversiblespiral down into more and yet more debt.

It seems to us that the financial crisis and theeuro-crisis have for the first time revealed thisproblem, to some extent at least. It is no coinci-dence that the risk premiums for state debt,

observable in the Credit Default Swaps, are, forthe first time in history, higher than those forprivate business debt. Unease at a situation canhardly be more effectively expressed thanthrough the prices paid in the market. To thisextent, what we see here is an explicitly ex-pressed unease. More important to us, though,seems a hidden, not really articulated unease. Inour view, this is what lies behind the rising rateof savings in the USA despite all the efforts tostimulate consumption; it lies behind the lowlevel of credit provided by the banks; it lies be-hind the sluggish private-equity situation; it liesbehind the inability, on both sides of the Atlan-tic, to get on top of the unemployment situation.The expressions of perplexity listed in Section 2above become a good deal more explicable if weinclude the variable of general unease in theequation. More and more citizens, business peo-ple, investors have a vague feeling that thingscan no longer work out right. Things: our so-cial and economic system has become so largeand so complex that it defeats its own ends; thewhole problem is so large and so complex thatultimately failure is inevitable. Or, in terms of

our metaphor, there is far too much tinder, andit is far too widely spread.

6. Counterproductive stimuliThe management of this build-up of tinder iswhat is known as system stability. This con-cept has developed into an apparently unlimited

free pass for the contravention of principles andguidelines, almost as pernicious as the publicinterest or raison dtat of days gone by.When the Swiss Confederation maintains a bigbank in its original structure, instead of putting itthrough an orderly restructuring process, moni-tored by the supervisory authorities; when thissame Swiss Confederation allows the bankingsecrecy it had previously upheld to be brokenretroactively, in disregard of the guarantee ofdue legal process; when the European Unionfirst saves Greece from bankruptcy and then

organises a bail-out for other affected membercountries in explicit contravention of legislationpassed for precisely this situation; when theAmerican government directly subsidises indi-vidual businesses via the Recovery Act; this allis being done in the name of system stability. Ithas become a free pass for the expansion anddelivery of further, ever more exorbitant indi-vidual claims and entitlements.

There are of course, as is to be expected in suchsituations, some, apparently academic, propo-nents of such unconstrained claims management.

For example, J. K. Galbraith, already quotedabove (p. 3). On the limits of state stimulation,he remarked that there is no operationallimit. The federal government can, and does,spend what it wants. Casual creation of debtsimply reflects energetic saving by others athome and abroad. As to what the expenditure isused for for real, feasible projects, or actuallynot, as the money ends up being socially redis-tributed or in misinvestments on this, the pro-fessor from Austin, Texas has nothing to say. InEurope too, there are a large number of advo-cates of activist state economic policy. They allmake the same mistake. They believe that alarge collective is in a position to meet and man-age claims, entitlements and activities in an ef-fective fashion. They will not see that thisplanned-economy misconception has resulted inthe ever more extensive accumulation of tinder.With increasingly desperate and interventionistactions, they keep attempting to put out individ-ual fires, and in doing so fuel the system withfurther supplies of tinder.

The final, and most important link in the main-tenance of system stability for this ever more

hollow construct consists of the central banksand, as since the financial crisis they have eitherbeen nationalised or are in a state of extensive


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regulatory and economic dependency on thestate, also the big commercial banks. With lowinterest rates and the financing of state debt viatheir balance sheets they ensure that stability is

not only talked into being, but is genuinelybrought into existence. The over-indebted de-veloped nations and communities of states needthe low interest rates and quantitative easingto prevent the fact that it is all tinder anywayfrom becoming obvious. In the name of systemstability the central banks have largely forfeitedtheir independence. They and the big commer-cial banks have degenerated into aiders andabettors of excessive debt, suppliers of tinder.

The problem is that every step in this directiongenerates more of what we have described as

general unease: the anxiety that the system inwhich the developed societies have entangledthemselves has become so big, so powerful, socomplex and so uncontrollable that it is bound tofail.

7. A quicker shift in the centre of gravityThis of course raises the question of how it canhave been possible to play this game for so long,entirely unnoticed by anyone, and above all bythe creditors. This is synonymous with the ques-tion of how long this low-interest period, mis-erably devoid of returns, can last. This questionis obviously highly relevant to the orientation ofinvestment activity.

In normal circumstances, that is, when a cur-rencys interest level and external value areclosely correlated, this sort of monetary andfiscal policy should have come to an end longago. The external value of the currency con-cerned would have come under strong pressureto depreciate, high import prices would havefuelled inflation, and interest rates would havehad to be raised. But these are not normal cir-cumstances. Rather, a sort of lowest-interest-rate cartel has come into being, led by the mostimportant reserve currency in the world, to-gether with the yen and the euro. This providesthe over-indebted societies with the necessaryliquidity. The other global trading currencies,including the Swiss franc, are not relevantenough to be able to challenge this monopolisticequilibrium. And the only ones who might, ascreditors, be able to disturb this lowest-interest-rate cartel, the Chinese, have little interest, forreasons related to their own highly importantexport activity, in changing this situation at all.

The long-term consequences for the developedworld could hardly be more negative. After thedeindustrialisation of the 1990s, as a result of

which the Americans lost a great deal of theirproduction capacity, the depth of value-addedand the capacity for innovation are now alsounder threat, as a result of the general unease

at the excessive size and complexity of the sys-tem. Core processes, hitherto closely guardedbusiness and production secrets, and researchand development are being transferred to coun-tries characterised by confidence and hope,rather than by general unease. What is beingsaved by companies on both sides of the Atlanticis being developed in Asia and Latin America.Hence our forecast that, as a result of the eco-nomic policy adopted by the developed nations,the centre of gravity will shift towards theemerging economies of the world far faster thanhad been supposed. What will be left will begeriatrics.

8. An insular ray of hopeThis might sound a bit exaggerated, too nega-tive, too bleak a picture. On the other hand, wecan just as well argue that the assumption thatthese highly complex, highly indebted, enor-mously large, ultimately self-paralysing socialsystems have any chance of survival would alsobe a fairly bold one. It seems strange to us thatintellectual circles in particular find it hard tothink in terms of structural hiatuses. In a collec-

tion of essays on Switzerlands relationship toEurope, recently published by the Swiss think-tank Avenir Suisse, the possibility that Europecould come apart as a result of the crisis is onlyconsidered in passing. Our previously expressedfear that the consequence of the profound finan-cial crisis might be compulsion or collapsefinds little reflection. Is it intellectually honest todeliberately avoid thinking the impossible, oreven the merely politically incorrect? Can rec-ommendations based on such a blinkered per-spective have any strategic relevance?

Too big and too complex not to fail. The onlygovernment in the Western world that has un-derstood both the problem and its urgency is theBritish. The programme that David Cameron,his sparring partner, Nick Clegg of the LiberalDemocrats and George Osborne, the Chancellorof the Exchequer, have put together deservesour attention. Firstly, the savings targets areextremely challenging: the budget deficit is to bereduced from 11 percent of GDP to 2.1 percentby 2014. But the structural proposals seem to usstill more important. Cameron intends thorough

decentralisation, because the central decision-making bodies have got themselves into a stateof highly complex inefficiency. Both the ideasand the programme of the new British govern-


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ment go far farther than those of MargaretThatcher. They turn the assumption that difficultquestions can only be solved by higher-orderbodies literally upside down.

One English swallow does not make a summer,and anyway, the government has to survive longenough to achieve (possible, but by no meanscertain) success. Nevertheless, when we considerthe enormous influence of Thatcherism onEurope and the USA (what is nowadays dis-missed as neo-liberalism), then it is at leastconceivable that the British reversion to disci-pline and decentralisation might develop into azeitgeist that renounces its love of scale andcomplexity. The opposite of too big and toocomplex not to fail is small, flexible, efficient,

private, individual._______________

What does all this mean for investors? Firstly,there is no reason to expect a rapid shift tohealthier economic and monetary policies in thebig and powerful industrial nations. The lowest-interest-rate cartel will last longer than we mightthink. Interest rates will stay low, there will beno inflationary pressure, the dollar, the euro andthe yen will fluctuate against each other excit-edly, but real pressure to depreciate will be felt

only by those currencies that cannot or do not

wish to belong to the cartel. Because of thegeneral unease at these monetary and eco-nomic policies, growth in the industrial nationswill remain slight, while the economic power of

Asia and Latin America will be further accentu-ated.

And stocks? For them to be really attractive, bywhich we mean annual returns between 20 and50 percent, as in the 1980s, we need a return toconfidence and happiness. A Yes, we can! notbecause of subsidies from a bankrupt entity, butbecause we want to finance it ourselves, andbecause the rewards of our actions are not likelyto be immediately confiscated. Luckily, theworld is big enough, and varied enough, thatsuch conditions do exist. And this is precisely the

focus of our new investment strategy and ourinvestment products. Well-run businesses arevery well able to cope with the prevailing condi-tions, and have long disengaged themselves fromterritorial dependencies and tribulations. So westill find broadly diversified stock investments(that is, feasible real projects) more attractivethan the guaranteed zero-return nominal valuesof ailing state debtors.

KH, 23.08.2010

W E G E L I N & CO . P R I V A T E B A N K E R S P A R T N E R S B R U DE R E R , H U M M L E R , T O L L E & C O .

CH-9004 St. Gallen Bohl 17 Telephone +41 71 242 50 00 Fax +41 71 242 50 50 [email protected] www.wegelin.ch

S T . G A L L E N B A S E L B E R N E C H I A S S O C H U R G E N E V A L A U S A N N E L O C A R N O L U C E R N E L U G A N O S C H A F F H A U S E N Z U R I C H

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Wegelin & Co - Investment commentary 272 - Too Big Not To Fail