Global Trends to 2025
(August 13, 2009)
Dear Subscribers and Readers,
One of my friends had lunch with Nobel Laureate, Myron Scholes (one of the men behind the Black-Scholes formula for pricing options) yesterday. Scholes is the co-founder of the hedge fund Platinum Grove (and also an advisor to LTCM). The business model behind Platinum Grove is based on the concept of outperforming the markets through picking up “omega” in the markets – which is simply a fancy term for providing liquidity to capital markets.
Ever since the dawn of the modern day banker, the Medici family, in 13th century Florence, financial professionals have been compensated (either directly or indirectly) through the provision of three essential services: 1) Act as an intermediary to those who want to defer (e.g. save for retirement) or bring forward consumption (e.g. borrowing money to buy a house); 2) Provide liquidity to the financial markets, sovereign states, or predominantly in the last 200 years, corporations and venture capital firms (e.g. investment bankers getting paid for an IPO of a corporation); and 3) Act as a kind of market-maker, who in turn makes the market more efficient and assist in price discovery and transparency. Aside from the NYSE specialists back in the old days, Jim Simons' flagship Medallion Fund comes close to emulating this model, which is one reason why this hedge fund has been so successful over the last two decades.
The above framework provides a clear picture of why financial professionals get paid, and more importantly for investors and financial professionals, the magnitude of modern-day fees and compensation packages. In addition, financial companies typically don't specialize in just one service. Financiers have historically branched out to other areas, such as adding value to their investments through operational advice or sitting on the companies' boards. The Morgan bank was famous for doing this, especially in the railroad industry in the late 19th century. Today, small to middle market private equity firms are instrumental in not only providing capital, but also operational advice and other services to the companies within their investment portfolios.
In general, financiers' rewards are inversely correlated with the magnitude of liquidity and efficiency of the markets in which they operate. The traditional/quintessential investment banker – that of the gentleman banker bringing a company's issue to the market for the first time – still enjoys some of the highest compensation in the industry, primarily because he or she operates in a very illiquid and “clubby” market. In addition, companies issuing stock for the first time (with the notable exception of the Google IPO) typically seeks out the firms with the greatest franchise value, as these firms are typically able to maximize the success of an issue. Studies have found that no amount of competition could dent the fee structure of the “bulge bracket” investment banks, despite Google's success with its “Dutch IPO' model in 2004.
Based on this inverse relationship between compensation and market liquidity/efficiency, it is thus no surprise that some of the greatest fortunes or transactions were made during times of great illiquidity and inefficiency. John Pierpont Morgan, for example, was able to snatch the Tennessee Iron & Coal Company for a absurdly low price to complement its steel holdings in the midst of the Panic of 1907. Not only did Morgan have the funds to purchase T&I, he also had enough funds at his disposal (most of which were not his) to reliquify the US financial market. In retrospect, Morgan could've easily multiplied his fortune if he had wanted to. Nearly 70 years later, Warren Buffett provided much-needed liquidity to GEICO in the midst of a record loss and shareholder revolt in 1976, as the company struggled to stay solvent in an era of highly inflationary medical costs and a general lack of cheap capital. This investment by Buffett, along with his investment in American Express during the aftermath of the 1963 “Salad Oil Scandal” and in Freddie Mac in the early 1980s, would disproportionally drive investment returns at Berkshire Hathaway for years to come. During the Great Credit Crisis of 2007 to 2008, Berkshire Hathaway would play this role of providing liquidity to the markets once again by investing $10 billion in GE and Goldman Sachs. In helping to boost investor's confidence and playing a “quasi central banking” role (the funds are not as important as Buffett's reputation among the masses), Buffett was rewarded handsomely.
Again, throughout history - going back to the Medici banking family - providing liquidity to the markets and making the markets more efficient has been the key to outsized risk-adjusted returns. The key is to have the appropriate information network (along with the necessary connections; e.g. deal flow in PE) and the reputation and the clout to execute the trade and helping to boost market psychology. Interestingly, Scholes' hedge fund, Platinum Grove, lost more than 30% last October and actually underperformed the average hedge fund. I may be the only person wondering about this but I am still trying to understand how he is able (or advertise that he is able) to implement this business model through a hedge fund vehicle. If one is providing liquidity to the financial markets in a period of market stress (which by definition would allow you these opportunities unless one is operating exclusively in the private equity or private real estate world) then one needs to have a substantial amount of cash (i.e. no leverage) and the ability to retain the cash (i.e. long lockup periods) during periods of market stress. Margin calls or investor redemptions could easily derail one's business model (and providing liquidity to the financial markets by utilizing leverage with other people's money hardly inspires confidence). Anyway, I will meet up with my friend and find out more about this tonight, but implementing this kind of business model via a hedge fund vehicle and using leverage just seems counter-intuitive to me.
Let us now get to the gist of our commentary. Every five years, the National Intelligence Council and the Central Intelligence Agency (CIA) publishes a “global trends” report that attempts to look out 15 to 20 years in the future and identify (or predict) the major risks, issues, and how the geopolitical world will evolve over that timeframe. As veteran investors will tell you, it is difficult to predict how the world will look like in 6 to 12 months, let alone 15 to 20 years (George Friedman, founder of Stratfor, who recently authored the book “The Next 100 Years: A Forecast for the 21st Century” stretches this even further). When authoring/issuing a series of these predictions, sometimes it is actually more fun to go back and review the issues that had not transpired, rather than those that actually occur. One thing I admire about American culture and institutions is the practice of reflections and reviewing one's mistakes – and use it as a lesson for future endeavors. Thankfully, the latest report, “Global Trends 2025: A Transformed World” does just that.
The report begins by comparing the conclusions of the latest report and the last one issued five years ago, entitled “Mapping the Global Future: Report of the Intelligence Council's 2020 Project.” While the 2025 report assumes a multipolar world (where the US is still the dominant geopolitical power but is only one of many global actors), the 2020 report projects continued US dominance, and predicts that other major powers have forsaken the idea of balancing the US (keep in mind that the 2020 report was published before the energy boom, not to mention the numerous academic studies on China since then). Most dramatically, the 2025 report concludes that China will achieve dominant geopolitical power in Asia, and will be marginally more powerful than the European Union by 2025:
Another major difference lies in their treatment of energy supply, demand, and alternative energy. Quoting the 2025 report:
In 2020, energy supplies “in the ground” are considered “sufficient to meet global demand.” What is uncertain, according to the earlier report, is whether political instability in producer countries, supply disruptions, or competition for resources might deleteriously affect international oil markets. Though 2020 mentions the global increase in energy consumption, it emphasizes the domination of fossil fuels. In contrast, 2025 sees the world in the midst of a transition to cleaner fuels. New technologies are projected to provide the capability for fossil fuel substitutes and solutions to water and food scarcity. The 2020 report acknowledges that energy demands will influence superpower relations, but the 2025 report considers energy scarcity as a driving factor in geopolitics.
In other words, the 2020 report assumed a world of plentiful fossil fuel supplies and consequently cheap energy prices. The idea that the world will remain static in 15 or 20 years is always a mistake that forecasters make. In the 2025 report, energy supplies are predicted to be as constrained if not even more constrained – that is why Russia is assumed to continue as a global power going forward. As many of you know, this author has a different view. The technologies to commercialize many efficient alternative energy sources are just now coming online. In just five years, we should witness the commercialization of much more efficient alternative energy sources such as cellulosic ethanol, algae-based biofuels, and solar panels that are more efficient.
Unfortunately (although perhaps not for the perma-bears), multipolar geopolitical systems have always been more unstable than bipolar or unipolar systems. Moreover, the 2025 report believes that “the relative power of various nonstate actors – including businesses, tribes, religious organizations, and criminal networks – is increasing.” While the report does not envision a complete breakdown of the international system (similar to what occurred during 1914 to 1918 after the end of an earlier phase of globalization), it nonetheless acknowledges that the next 20 years of evolution and transition to a new international system will be fraught with risks, although it is definitely a story with no clear outcome, given the thousands of variables involved and our ability and will to solve difficult problems such as resource constraints and technological bottlenecks.
Going forward, I will continue to keep you abreast of all the major geopolitical and investment trends that will transpire over the next 10 to 20 years. This weekend, I will also pen a more personal commentary outlining what my deepest thoughts are regarding the future of our financial system and where the major investment themes/opportunities will lie.
Henry To, CFA