By Paras Anand, CIO of Artemis Investment Management
Nassim Nicholas Taleb first popularised the concept of “black swans” in a book published in early 2007. Only months later the world witnessed just such a phenomenon: the global financial crisis.
One of Taleb’s key arguments went relatively unnoticed amid the turmoil. A broken system should be allowed to fail, he said, as this helps protect against the black swans still to come – whereas simply propping up a defective construct only renders it even more exposed.
The shift from quantitative easing (QE) to tightening and the rapid rise in interest rates as central bankers battle to contain inflation have brought volatility to capital markets. Though the S&P 500 index is up 21% from its low last October, this rally has been led by a very small number of stocks, suggesting market fragility.
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We have seen war in Europe and Putin’s regime under threat, a cost-of-living crisis, the fall of the third-largest bank ever to fold in the US and the bailing out of a long-time European financial powerhouse. It would be ridiculous to suggest these are trifling occurrences, but if a golden age of easy money has given way to a search for silver linings then there are plenty to be found. Inflation has lifted wages for the first time in years and enabled companies to recalibrate prices. Even business failures can offer encouragement.
QE and Covid
As Taleb suggested, an inherent feature of any genuinely robust system should be that it is in some way Darwinian. Economically, the survival of the fittest is an essential component of its sustainability.
QE did not entirely disrupt this process, but it was designed to make life easier for companies by making debt cheaper. Many companies that should have folded in the past decade stayed afloat. Others overexpanded.
Just as central bankers were beginning the job of reversing QE, Covid arrived. Government-backed furlough schemes temporarily removed the Darwinian element altogether, effectively ensuring that nothing should be allowed to fail.
This led to a market environment in which good management was often not fully rewarded and bad management was frequently unpunished. Many companies willingly entered a self-induced coma, secure in the knowledge that life support was at hand and issues such as customer acquisition and market share need not concern them unduly.
In time, of course, these businesses awoke to discover the world had changed dramatically. Such “zombie companies” now account for a sizeable proportion of the firms struggling to survive or closing.
Meanwhile, many businesses that were already resilient and which continued to adapt and innovate have emerged even stronger. In tandem, the investors who backed them can now increasingly expect to benefit accordingly.
The natural order
In turmoil lies opportunity. The trauma in March in the banking arena provides a neat illustration. Consider the respective fates of Credit Suisse and its saviour, UBS, and how they eventually intersected.
Credit Suisse had been embroiled in a variety of scandals in recent years. The Archegos default, the Greensill Capital collapse, the Mozambique tuna bond fraud, the Bulgarian cocaine traffickers’ money laundering scandal – these incidents sound like ever more bizarre chapter headings in a pulp-fiction novel. They damaged the bank’s reputation, and the losses and fines ran to billions. Credit Suisse underwent a series of shake-ups at executive level and suffered substantial losses.
By contrast, UBS made a string of shrewd moves while maintaining a focus on prudent risk management. Its investment banking division posted especially impressive numbers during the pandemic. The $3.2 billion purchase of Credit Suisse – which the Wall Street Journal touted as “the deal of the decade” – was the culmination of many years of sound decisions.
So a poorly managed company put itself in a position to fail. A well-managed company put itself in a position to grow. And, thanks to the broader robustness of the system, the world kept turning.
Signs of life
Today feels like the end of the 1990s and early 2000s. Markets were volatile; the NASDAQ fell dramatically; Enron and WorldCom went bust; but the economy, in aggregate, was reasonably healthy.
Critics will say, with some justification, that QE endured for too long. Covid extended it. Coming off the drug of cheap capital will not be easy. Its withdrawal has led to isolated failures – and will lead to more. But each failure need not be a portent of all-pervading catastrophe. What we are witnessing is the unwinding of excesses and the natural cycle of disruptive innovation. These are signs of a healthy economy.
Investors sometimes need to step away from the screens and ask if markets are fully reflecting what is happening outside. I would argue not – the real economy feels more robust in aggregate. For the selective investor who backs good companies and good management, herein may lie opportunity.
