Strategic View

Do Markets Need Government?

When I studied and taught economics 25 years ago, the basic model of efficient markets was straightforward. Investors and businesses maximize profit, consumers seek value for money, workers search for lucrative jobs. Competitive market forces were central, although market failures were acknowledged: the maldistribution of income and “externalities” such as pollution and crime that are not reflected in market prices. The role of government was to efficiently remediate these failures, to regulate, tax or otherwise “get the prices right.”

What happens, however, when self-interested capitalists understand that social inequities and externalities like pollution and nuclear proliferation do long term financial damage to their portfolios? Short term profit-driven activities (e.g., extracting oil) may turn out to be terrible long-term investments (rising sea levels threatening major cities and markets). What if markets begin to demand, either for altruistic or self-interested reasons, better performance from corporations on multiple bottom lines? In such a system, does the role of government diminish?

It is tempting to say yes. Institutions with long term horizons, such as foundations and public pension funds, are teaming up with social investors to address “extra-financial” market risks, taking action through the Investor Network on Climate Risk (or INCR, which represents $4 trillion in assets), signing the UN Principles for Responsible Investment (more than $10 trillion in assets), and insisting that companies report on extra-financial performance through the Global Reporting Initiative. These massive investor networks own large chunks of the global corporate sector. If they demand that corporations act responsibly, externalities should diminish, reducing the need for regulation.

In fact, these market forces are extremely useful and leading to meaningful change as companies respond accordingly. Carpet manufacturer Interface‘s vision is “to be the first company that, by its deeds, shows the entire industrial world what sustainability is in all its dimensions: people, process, product, place and profits – by 2020 – and in doing so …become restorative through the power of influence.” But not every company embraces such a deep vision, and systemic performance on social and environmental issues is simply not improving fast enough. Government remains the only actor that can ensure a price on externalities (through taxes and regulation), while requiring full disclosure of extra-financial information.

When government is needed most, it is too often seduced by lobbyists and beholden to corporate interests. This is an old problem, identified a century ago by Woodrow Wilson, who warned that “the government, which was designed for the people, has got into the hands of the bosses and their employers, the special interests. An invisible empire has been set up above the forms of democracy.” But wise investors and corporations understand government’s crucial role. That’s why members of INCR have been calling for the Securities and Exchange Commission to mandate environmental reporting, and employer coalitions are requesting that the government regulate carbon sooner rather than later.

Our Current Market Outlook

The stock market is off to a dismal start in 2008. There has been some panic selling that we believe overstates the true underlying risks to the economy and financial markets. As discussed in our Economic and Social Outlook – January 2008 [PDF], we perceive that recession risks have risen to 50%, and are pursuing a more defensive strategy. While the market was perhaps due for a correction after five straight years of gains, we believe that conditions are likely to stabilize later in the year. Aggressive monetary policy (including a dramatic 0.75% cut in interest rates by the Federal Reserve on January 22nd), combined with upcoming fiscal stimulus efforts, will help the economy find a bottom, and the stock market generally anticipates these improvements by at least three to six months. From the perspective of long-term wealth building, patience is a great virtue in the face of volatile and difficult markets like these.

What’s Going On In The Markets, Vol. III

From 1960 through 2006 the odds of stock returns being positive in the 4th quarter were 78% and the average return was 4.17%. This gives the 4th quarter the best odds and average returns of any quarter in the year.The strongest returns have come in 4th quarters where the economic backdrop is soft and the Fed is cutting interest rates. This, of course, is precisely the position we find ourselves in as we approach the 4th quarter of 2007. A slumping housing sector has weakened the overall economy and yesterday the Fed cut interest rates for the first time in four years.

One might wonder why a weak economy should be conducive to strong stock returns. Doesn’t such weakness threaten recession and thus pose a serious risk to stock prices?

There’s no doubt that a recession would be damaging to investors as corporate earnings would collapse, dragging stocks down with them. And that is a risk at this juncture. But that risk was reduced materially yesterday by the Fed’s decision to lower interest rates by half a percent. Strong exports and healthy corporate balance sheets reduce recessionary risks, offsetting some of the problems in the housing market.

We’ve argued for some time that our ace in the hole with regard to recession risks is the Fed’s ability to cut interest rates from their recent level of 5.25%. Lowering interest rates is one of the most powerful economic tools at the Fed’s disposal. Bernanke & Co. signaled clearly yesterday that they won’t be shy in using it.

And that’s why a soft economy in the fourth quarter is conducive to rising stock prices: Because it’s also conducive to the Fed lowering interest rates.

While we can expect the usual chorus to rehearse a litany of reasons why the Fed’s actions won’t work this time, history suggests the Fed will succeed in averting recession. If the Fed succeeds, corporate earnings will continue to rise. And that is what stocks are anticipating when they rise despite a weak economic backdrop.
As we noted during the market turmoil of August, what we’re seeing fits the typical pattern at this point in the economic cycle: Some economic crisis arises, the economy slows, the Fed cuts interest rates (in effect gunning the engine of the economy), recession is avoided and the stock market and economy recover (in that order).

This happened in 1985 and in 1995 and we believe the economy and stock market are following a similar script in 2007. The low in economic activity will likely register in the 4th quarter of 2007 with an economic recovery unfolding in 2008. That recovery should be anticipated by stock gains six to twelve months prior. And, indeed, we got a taste of this yesterday with the market’s largest one-day percentage gain in four years. Stay tuned.

By Farnum Brown, Ph.D
Trillium Asset Management Corp.