‘Market volatility: any cure is worse than the disease’

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July August 2015 Opinion James Sproule Financial Markets and Volatility

James Sproule says the increasing unpredictability of financial markets is a price worth paying for business flexibility

One of the pleasurable things about my role at the IoD is that I get to meet so many interesting people. Recently, I had breakfast with a Nobel Prize-winning economist. We discussed the state of financial markets and the economic future more generally. As part of our talk we touched upon the question: why are financial markets more volatile now than they were in the past?

My explanation was as follows. A generation ago, companies whose operations required a significant asset base owned that asset base. Moreover, those assets were accounted for on a balance sheet at ‘book value’ – a valuation that was as often as not some way below the realisable ‘market value’.

No one was all that concerned that the assets were not revalued, because if you wanted to be involved in that business you had to have the capital assets to operate. This had all sorts of effects, with two being particularly striking. Requiring operators to own their own assets greatly limits competition; new entrants need to make a significant investment before they can earn any revenues. Secondly, that moving away from holding undervalued assets on a balance sheet introduced a permanent rise to the volatility in the overall economy. So what is going on?

Investment bankers (full disclosure: I was one of them) advised companies that they could use their balance sheets far more efficiently if they sold their fixed assets and leased them back from a dedicated asset manager.

The argument went that companies, often in areas such as retail or industries such as shipping or airlines, which have large long-life capital assets, were not in the business of managing assets – they were in the business of selling goods or services. In fact, owning assets limited flexibility to grow rapidly, or shrink costs when required. This logic presented by investment banks made (and still makes) sense.

Coming from investment banks the logic may have been self-serving, and the ultimate result of introducing much greater competition may not have been the intended one, but once the cost race was started it was difficult for corporate bosses to ignore. As more assets are monetised – that is have regularly updated financial values attached to them – it is inevitable that the overall capital value of companies will fluctuate.

Economic volatility can at times appear undesirable, and some commentators may even urge the government to do something to reduce the swings in financial market valuations. But volatility is one of those many cases where almost any cure is worse than the disease.

A degree of volatility is essentially the price that has to be paid for vastly increased flexibility. Thankfully, most business people are likely to respond by building ever more agility into their businesses. They will do this not because they expect to put themselves into consideration for a Nobel Prize, but because they recognise that for better or worse (and it is almost invariably better) that is the new reality.

@jamesrsproule

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James Sproule

James Sproule

James Sproule has been Chief Economist and Director of Policy for the Institute of Directors since January 2014. Prior to joining the IoD James led Accenture’s UK Research and Global Capital Markets Research. He started his financial career as a merchant bank economist working with both Bankers Trust, Deutsche Bank and Dresdner Kleinwort, and eventually helped to found the boutique bank Augusta and Company.

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