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The October Revolution and the New Socialism

October 31 2008

In Russia in 1917 the October Revolution heralded the end of the Imperial Era and the beginning of Socialism as an economic system.  Unlike the French Revolution, the Russian revolution ultimately resulted in a centralized government that took control of the financial capital of the country, and attempted to organize the human capital into collective farms and factories to produce the needs of the people.  Having had the privilege of visiting Russia and seeing its rich architectural history it is not surprising that peasants and workers rebelled at the excesses of Czar and his elite.   The contrast between Socialism and Capitalism were clearest around the role of government and production quotas, versus the role of financial capital and the creation of profit in an open market economy.  When Socialism eventually failed and gave way to the “New Capitalism” in Russia, the capitalist world hailed the victory and opened the doors to business in China.  Quick to exploit the low wages in these emerging markets, America and other developed countries watched as companies relocated their factories and jobs in these new places. These new factories were financed by US and European capital or from money borrowed from the Japanese banks at very low interest rates.  Along with new factories came new markets based upon new consumers created from their new wages.   The slow withering of the domestic manufacturing engines of the US and the UK slowly gave way to them becoming centres for capital management for both local and global markets. Without the increase in real income, consumers started to spend more and more on credit. The US and European governments followed suit. Cheap mortgages, fewer control checks and soon the best business to be in was selling credit, through mortgages, car loans, credit cards and consumer debt.   The Investment Banks who understand the economic and investment implications became conduits for massive capital, with the local and global risks being packaged and sold to insurance companies who understand them.  The result was supposedly risk free returns appraised by rating agencies that would perpetuate capital growth. Referred to by some as “the smartest guys around”, investment bankers and their colleagues the hedge fund managers who earned performance bonuses which dwarfed other professional incomes, pushed back against regulatory oversight, advocating that open markets are best left the regulate themselves through market dynamics.  Alan Greenspan, the former Fed Chair for twenty years advocated for this deregulation, and soon after he retired became a lead advisor to a hedge fund which profited significantly from betting on the credit failure. Henry Paulson, former CEO of Goldman Sachs also a strong deregulation advocate moved the other way into government  and the oversight position of Treasury Secretary.     Then the markets blinked! Slowly the world became aware of the sub-prime mortgage fiasco, which had fuelled consumer spending. As defaults rise the solvency of the underwriters and mortgage guarantors  has begun a domino effect. The derivatives of these credit instruments including Asset Backed Commercial Paper, Special Investment Vehicles, and Credit Default Swaps among others have created a crisis of confidence within the banking community.  Unsure of the real exposure, banks have been shy of lending to other banks in the wake of the failure of Lehman Brothers. What we are witnessing would have been anathema to the markets a few years ago, and it can only be described as the “New Socialism”. The biggest mortgage underwriters in the US, Fannie Mae and Freddie Mac, were put into a government conservatorship or effectively nationalized, AIG the largest insurance company was forced to dilute 78% of its ownership to the Federal Reserve of New York, US Banks who have accepted bailout provisions have seen the US Government effectively take ownership in their companies.  Today the car manufacturers were asking for financing assistance from the government to tide them through the liquidity crisis.  Governments around the world have nationalized banks, guaranteed deposits and interbank loans, have slashed interest rates, have purchased corporate debt, made funds available to banks through their “discount window”, and even made finance available to other countries through the IMF or direct lines. The IMF loans to Hungary, Pakistan, Iceland, Argentina, Poland and others signal significant systemic weakness, with global volatility expected to continue in currency markets.   The scale of government and central bank intervention during September and October has been unprecedented, and speaks to the residual concerns that continue to exist.  Ben Bernanke gave a speech in November 2002 before he was the Fed Chair in which he outlined the strategies and tools that the US Fed may have available to combat deflation. His remarks earned him the nickname “Helicopter Benanke”, as he stated that the ultimate way out of deflation is to have the government “print” more money.  In understanding somewhat his remarks it is worthwhile to note that Japan had experienced steady deflation since the early 1990’s brought about in part by the uncoupling of its currency with the US$ and the poor regulatory oversight of its banks and financial institutions.   Many of his comments about Japan apply directly to the situation in the USA and the impact on the global financial markets today.  Interest rates from the central banks are at all time lows, and with so many of the tools already exhausted we are in uncharted territory.  Market volatility is huge with intra-day moves in the double digits.  In 1998 when faced with the loss of confidence that resulted in the collapse of the Hong Kong stock market, the Hong Kong Money Authority actually stemmed the flow by stepping into that market and bought company shares.   With consumer and investor confidence at record lows, it is probable in the face of such uncertainty that consumer spending will shrink, and statistics out yesterday for September show the largest contraction in consumer spending in over 30 years.  While commentators want to avoid using the word “Recession”, everyone shopping on main street knows that it is already upon us. The questions now should be how deep and how long?   November will see a global summit of the world leaders of the top 25 industrialized countries on how to combat the global recession and deflation.  President Sarkozy of France the current EU Chair has already called for global reform and oversight of finance and banking. Alan Greenspan admitted embarrassedly before the Senate Finance Committee that his view of the markets was wrong, and that more oversight is needed. It is clear that without the unprecedented intervention that we have seen in financial markets, our retirement savings and pension funds would likely have suffered more. Governments around the world now know that the financial future of their citizens cannot again be left unsupervised, and will strive to find a concerted way forward for if they don not hang together, they shall surely hang alone!  However we do not expect sudden magic from this summit. The reality is that those of us who have seen the value of our homes and retirement savings drop, know that we will need to be more careful of costs. We will spend less and likely try to save more, creating a drop in demand for discretionary purchases which will ultimately impact manufacturing, retail and consumer services and the jobs they provide. A global recession is inevitable and further international stock market declines may well happen before there is a real bottom. While we are unsure of the final outcome of the “New Socialism” being exercised through the control of capital by governments around the world, and their harmonized actions and interventions, what we have witnessed this October is a real revolution against the Wall Street Czars and their perceived “sense of entitlement” and “excessive compensation”.  It may not be a revolution that involved guns and riots but this October Revolution will have a bearing on the future of the role of governments on how capital is managed, perhaps more profoundly than the Russian Revolution.   “Mark Time” is a military command to march to the drum beat but on the same spot. While this may sound senseless it is a useful way to bring a squad of men into right position and into the same step, and to allow for a change in direction within the parade. In light of our continued concern with the macro-economic model we believe that it is not yet the time to be increasing exposure in the market. Our concern for equities that historical dividends will likely face significant drops in this recession is mirrored by our concern that high-yield corporate bonds may be battered by defaults and rising risk premiums.   We therefore believe that it is necessary to “mark time” to gain a better perspective and align our thoughts.  November’s Summit will provide some guidance for this and we respect your trust in us and your patience as we try to look for secure ways to rebuild from the losses which we have all shared.   Best Regards,

Victor Whang      Malcolm Ross       Violet Smith 604.331.2524  604.331.2521    604.331.4465 DISCLAIMER: E&OE: Investment Fund values change frequently and past performance is not indicative of future performance. No guarantee is given or implied and there is risk of loss as well as the opportunity for gain when investing in mutual funds. Sterling Mutuals Inc. © 2008