Tuesday, October 22, 2013

Strategic Thinking: In Some Serious Demand These Days

It was not my plan to add to the collective diatribe on Washington dysfunction regarding the recently resolved….for now…..government shutdown and debt-ceiling debacle. After all, such brushes with self-induced cataclysms are becoming semi-annual affairs, nearly all of which have either been narrowly averted or come to pass without dire warnings of the apocalypse materializing (think the sequester). But when the most recent iteration threatened to interfere with a late season fly-fishing excursion into the callously-shuttered local national park, it hit too close to home, thus prompting my contribution to the crisis’s post-mortem. And yes, this makes me a shallow, selfish soul.

Rather than naming political winners and losers or guessing the impact of the shutdown or possible default on the economy and financial markets (with a default being catastrophically worse), we instead will use the ghastly episode as a case study on strategy and tactics. Put another way: why it is necessary to formulate a strategy to accomplish certain goals and how incremental tactics can either contribute to, or scuttle, the chances of achieving major objectives. Failure to understand the difference between strategy and tactics and the important roles each play….which unfortunately is too often the case….can lead to serious ramifications for policy makers, financial professionals or anyone else facing life’s major decisions.

Taking a strategic view can best be defined as identifying a goal, establishing a general path to achieve it and then along the way repeatedly asking the question: what’s the worst thing that can happen? Not just in the here-and-now, but as any chess player of intermediate skill understands, five to ten moves ahead. In financial parlance: solid risk management. Tactics, on the other hand, are the more immediate decisions taken to achieve an established strategy. Some may be productive and take one closer to his or her goal. Others, not so much. The latter are the kind that can result in steep losses, margin calls, a trip to the emergency room or your sixteen year-old being grounded for the remainder of the summer.

In the past, these pages have inferred that 21st century American culture is centered on the ignoble concept of instant gratification.  This what have you done for me lately mentality may be fine when lamenting the recent travails of one’s favorite pro sports team (yes I am speaking of yet another Braves early playoff exit), but it is hardly a sound way to run one’s personal finances, an investment portfolio or approach any policy decision critical to the nation’s solvency, growth prospects or national security. While other regions of the world certainly are capable of similar short-sightedness, it is the U.S. that continues to provide ripe examples of consequence-free decision making.

Listless At Sea
While largely neglected since the 2012 election cycle, foreign affairs are within the scope of these pages, and it is here that one can find striking examples of the (real) dangers of misalignment between tactical decisions and an overarching strategy.  The current administration is rightly lauded for waging a successful campaign of taking out key Al Qaida operatives, often utilizing the controversial, but viciously effective, drone program. Great tactic: the fewer extremists to plan the next bombing against civilian-populated soft-targets the better. But one cannot substitute tactical victories for having a coherent, long-term strategy. At present the efficacy…or even existence…of an intelligible foreign policy framework is questionable. This is especially true when visions of altruistic rapprochement are initiated with undemocratic regimes, whose brass-knuckled leadership are well-versed in machtpolitik and likely have key passages of Machiavelli’s infamous treatise on the subject committed to memory.  Russia may not wield the geopolitical power it did during the Cold War, but given its position as a permanent member of the U.N. Security Council, it has been able to thwart numerous western-led initiatives aimed at its ally, Syria. So much for hitting the reset button.

The absence of a forceful American position during the first two years of the Syrian conflict may have seemed like a cautious tactic at the time. Fearing that some elements of the opposition were Islamic extremist, and not wanting a repeat of Afghanistan in the early 1980s, the administration remained on the sidelines. But in a vacuum, someone is bound to step in, and rest assured, the extremist element has done just that. If Al Qaida wasn’t in Syria in 2011, it most assuredly is now and is likely marginalizing any western-tilting members of the rebellion.

Speaking of vacuums: in Egypt, Hosni Mubarak was a heavy-handed dictator, but for three-plus decades he was our heavy-handed dictator. That is not to say that America’s strategy of aiming to exert pressure on his plutocratic and oppressive regime to reform the Egyptian political and economic systems was wrong. But to pull the rug out when it was clear the only alternative was the highly mobilized (from decades of organizing in the shadows) Muslim Brotherhood was in retrospect, clearly a failed tactic, which has put longer-term U.S. strategic interests in the region at risk. Yes one could take issue with the Freedom Agenda of George W. Bush’s administration. And his painting of global issues in black and white, could come off as moralistic and grating, but at least it was a clearly defined strategy and both friend and foe knew where he stood.

Speaking of moralistic and grating: the position taken by a small cadre of GOP house members….egged on by an even smaller cadre of senators…would be fine if one’s job was that of a blathering talk radio host. But the tactic fell woefully short of a legislator’s primary responsibility, which is to effectively manage the affairs of the government. While their strategic aim of delaying the new gargantuan healthcare law and limiting runaway government spending may have been admirable in the eyes of many, their tactics were abysmal. Part of developing a sound battle plan is to understand the landscape as well as size up the opposition. With regard to the former, the votes simply were not there, thus highlighting this gang’s lack of legislative chops. Concerning the latter, they failed to recognize that the media was in the tank for the other side and the opposition’s front man is a master at browbeating, vilifying and degrading those who don’t share his Socialist Europe, circa 1975, worldview.

A better tactic would have been to drink a few Red Bulls, keep the senate up all night in an anti-Obamacare filibuster…OK, they did that… then take a defunding vote. One, as in singular. Once it was on the record (for the umpteenth time) that they vehemently opposed the law, they could adopt the position vis-à-vis the Democrats: “you broke it, you own it.” One lives to fight another day and seek future tactical victories when on sounder footing. Instead, the strategic aim of stopping the ACA is no closer to being realized and the GOP’s brand is even more associated with primeval cave dwellers with only a rudimentary knowledge of wielding blunt tools, much less crafting workable legislation.

The other shoe to nearly drop last week was the brush with a U.S. government debt default. The path that led to this potentiality serves as yet another example of short-sighted tactics. Hollering about the government’s need to address the nation’s debt and its true drivers may be necessary to awaken the country’s populace from its blissful, reality-TV filled stupor. But doing so by threatening the full faith and credit of the financial instruments underpinning the global financial system was not the way to go about it. Legislators were possibly unaware of the role short-term U.S. government paper plays in interbank lending and as the risk-free asset upon which countless other financial instruments are priced. Or they did know and simply acted with reckless abandon.

It is clear that the status quo of government debt reaching even more unsustainable levels cannot continue. The strategy of borrowing from foreign creditors to spur domestic consumption (often on said foreign competitors’ wares) has run its course. It will take a tectonic shift in the mindset of national leaders to refocus America’s  economy from a consumption-driven growth model. The country has gotten away with it for so long partly due to foreign central bank demand for Treasuries and the role of the Dollar as the world’s reserve currency. It cannot be guaranteed that these aces in the hole will continue…at least at their present strength…far into the future. Yes, the deficit has declined in recent years, but that is partly due to a drop-off in spending from the automatic stabilizers initiated at the height of the financial crisis. Also at play are miniscule interest rates, which enable the U.S. to currently finance debt on the cheap. Eventually rates will tick up. When that occurs, interest payments on the 100% debt/GDP will skyrocket, leaving hell….or the Chinese… to pay. The U.S. may be a second rate soccer nation, but it matches Europe toe-to-toe at kicking the can down the road when it comes to substantive fiscal reform.

The Wise Men (and Woman) At the Fed
Unlike congress and the administration, the Federal Reserve has clearly defined both its strategy and tactics. The former is to spur growth (and employment) and, perhaps more importantly, stave off a borderline-deflationary lost decade of economic malaise, which, by the way, we are nearly halfway through, but who’s counting? The tactics are low interest rates, printing money to the tune of $3 trillion-plus and explicit forward guidance on rates, with none having performed as advertised. While the Fed may have a plan, the problem is that it is in uncharted territory, especially for the world’s largest economy. With examples of outlier risks on one side being post-1990 Japan, and Weimar Germany on the other, the new Fed Chairman will have an arduous task of spurring growth without getting behind the eight ball on controlling inflation.

Strategic Investors a Dying Breed? Let's Hope Not.
The world of investing is a unique animal as one’s strategy can either be long-term or short-term. Over the decades, the buy-and-hold strategy favored by conservative institutional investors has been a winning one. Once long-term goals...such as future pension payouts….are identified, incremental tactics ranging from adjusting asset allocation weightings to layering on hedging instruments to smooth out volatility can be adopted. More recently, as has been illustrated by the proliferation of hedge funds and algorithmic trading, several large investors focus almost exclusively on harvesting short-term profits. In contrast with old-school, long-only funds, whose performance is measured on one, three and five year ranges, these new portfolio managers are often judged monthly. Not for the faint of heart.

Yet it is possible. Perhaps even more than long-horizon investors, these traders…and that’s what they are…must have rock-solid risk management and an exit planned for every position in case it turns against them, which is often the case. As the saying goals: minimize losses while maximizing winners. With such a short-term strategy, the only tactics involved are determining position sizes, identifying stop-losses and how much espresso to drink before tethering oneself to the Bloomberg terminal. And not junk coffee served out of a paper cup with Halloween-themed flavors, but the real Italian stuff. Just sugar, maybe some cream.

Sadly…and keeping with the contemporary American mentality….this instant-gratification approach to investing is endlessly pitched to the general public, despite a large majority of them being completely unaware of the risks involved and the difficultly of generating consistently positive returns when utilizing short-term strategies. But from the country that relied upon subprime credit to fund 20-somethings’ purchases of BMWs and McMansions, rather than upon years of hard work, discipline and savings, what is to be expected?

Equally troubling is the predicament in which erstwhile conservative investors find themselves. Economic growth remains lukewarm. Fundamentals such as earnings growth have cooled off considerably after a forgettable post-crisis rebound. And emerging markets…one of the few stars in the immediate aftermath of the 2008 calamity…once again have their own hornet’s nest of issues. That pretty much leaves oceans of QE-generated liquidity trying to find a respectably yielding home as the driver behind the S&P 500 reaching yet another record high this week. What is a fundamental investor to do? Either stick to his guns and risk falling behind the benchmark (and face massive redemptions from ticked off clients)? Or throw strategy to the wind and follow the trend in search of an artificially-generated….and likely fleeting…. payday? Thanks to Fed involvement in financial markets, many a portfolio manager may wilt under pressure and adopt tactics that eventually could threaten the attainment of their financial goals.

1 comment:

Richard Lewis said...

This was an exceptional post that seamlessly combined philosophy (goals vs. tactics), politics, foreign affairs and financial investing into one tidy column. I commend the author for his interesting thoughts.