Agcapita UpdateJuly 26, 2012

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THE RETREAT OF FINANCIALISATION

Let me start by saying that I do not adhere to the mistaken belief that banking is intrinsically “bad’. Banking and finance serve a productive purpose in the economy by intermediating savings and investments. However I believe that what passes for much of modern banking, or more accurately post 1971 banking with its dysfunctional central bank/private bank nexus and its anti-competitive nature courtesy of regulatory barriers to entry, is not productive and is actually acting as an impediment to the underlying economy by destroying vast amounts of real capital - aka bailouts.

So with that context in mind, I believe it is putting it mildly indeed to say that we have arrived at a point where the vast majority of financial institutions are simply regulatory oligopolies with asset-harvesting business models more concerned with fees and proprietary speculative activities than with providing any useful services to savers and retail investors. The mainstream financial sector has indoctrinated an entire generation to buy and hold because it suits their business model that is asset-driven rather than performance-driven. Large financial firms have an intrinsic institutional bias to be bullish on everything - they have no incentive to tell you not to invest in something as they will usually be operating a fund in that area. Hence such sophistry as being “underweight” unattractive asset classes rather than encouraging outright selling. Ultimately they have little investment insight other than everything will go up in the long-run. Of course in the long-run it has been quipped that we are all dead. To add insult to injury they seldom outperform their benchmarks over long periods and charge management fees for what is effectively closet indexing.

Agcapita Update

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Agcapita Update (continued)

Once again, I am not a knee-jerk critic of the financial sector but I do believe that it has become too large. Corporate profits attributable to the US finance sector were effectively stable from the 1950s to the early 1980s from 5% to 15%, then as the growth in the money supply turned sharply higher on a sustained basis in the 1980s they peaked at 40% in the early 2000s and still remain around 30% - substantially higher than long term averages.

On an asset basis the numbers tell a similar story. The 20 largest banks in the US have combined assets of approximately 90% of GDP. The five largest banks - JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, and Goldman Sachs - have combined assets of approximately 60% of GDP. These numbers are roughly 3 times what they were in the 1990s. Given the finance sector’s intimate relationship with government and central banks it is not surprising that it grows faster than the underlying economy. Newly printed money flows into and through the finance sector acting as a wholesale subsidy that drives corporate profits, compensation and speculation. Despite widespread belief to the contrary, government intervention into broad swathes of the financial sector to support “too big to fail” banks or, more accurately, to prevent capital destroying business activity from being eliminated to the benefit of the entire economy is not a positive for future growth. When it is funded via expansionary monetary policy it seems to me that at best it is laying the groundwork for stagflation.

There is an economic truism that whatever you subsidize you get more of - hence by subsidizing failure we are ensuring bigger failures in the future and worst of all penalizing well-run businesses. The

firms that were prudently managed leading up to the crisis should have benefited from the demise of their poorly-run competitors - in a free economy capital would have flowed to the profitable businesses rather than the loss making ones. The fact that this didn’t happen creates a perverse “if you can’t beat’em, join’em” mentality with respect to risky and imprudent business practices. Lets be clear on one thing, the primary purpose of low interest rates is not to save the economy, it is to save the banks and allow them to continue all this risky, bonus-generating behavior. Low interest rates are simply a case of robbing Peter to pay Paul as capital is being “strip-mined” from savers via low interest rates and in effect “donated” to the financial sector. I would argue that the enormous size of the financial sector coupled with its current insolvency, which the constant bail-outs are attempting to disguise, will be a drag on growth for years unless losses are allowed to take place via free market mechanisms. Perhaps another interesting indicator of the financialisation of western economies is the ratio of the Commodities Research Bureau Index versus the S&P 500. The long-term average is around 1.5 times. Simplistically, this ratio indicates how much S&P 500 stock you can buy with a fixed basket of commodities – a rough indicator of the growth of financial assets in relation to real assets so to speak:

– During the commodity bull market of the 1970s, the ratio was consistently higher than 2 times for over 10 years - it peaked at around 4 times.

– The ratio is currently at around 0.2 times - far below the 1.5 times long-term average and far below the 4 times peak seen in the last

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Agcapita Update (continued)

commodity bull market. We still appear to be at an all time low relative valuation between “hard assets” versus “financial assets.”

– If history is a guide, the ratio of real assets to financial assets will return something closer to its historic average.

– How? Stocks will fall and/or commodities will climb – most likely a combination of both as

investors seek safety outside of the insolvent financial system and financial assets.

I would not suggest that this ratio is perfectly predictive, but it is certainly food for thought and perhaps another data point supporting the premise that the process of financialisation will tend to retreat rather than grow from here.

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