Politics, yet again, clouds the investing outlook. If we could invest simply according to the economic fundamentals, life would be relatively straightforward. The global economy is in reasonable shape: the US is resilient and has decent growth momentum, with wage gains supporting the consumer; the Fed is responding with rate hikes, but at a very measured pace. Europe has been growing as fast as can be expected, given its challenging demographics. And China has seen a stabilisation in ‘old economy’ sectors, thanks to targeted economic stimulus. Deflation fears have subsided as commodity prices recovered from their February lows.
One might quibble about valuations in some markets or assets, but there would be little doubt that the economic cycle continues to develop, that central banks were supportive and that corporate earnings would continue to grow for a while yet: a rather benign mid-to-late cycle investing environment.
Investors face a higher than usual concentration of political risk and policy uncertainty to muddy the waters.
Unfortunately, it’s not quite so simple. Investors face a higher than usual concentration of political risk and policy uncertainty to muddy the waters. In the US, that we have a political regime change is obvious, but markets do not know which President Trump they are dealing with. Is it the Trump of fiscal stimulus, potentially a huge short-term boost for the US economy, albeit very inflationary? Is it the Trump of protectionism, tariffs and forced de-globalisation, a disruptive force putting obstacles in the way of economic efficiency and imposing extra costs on consumers? Is it the Trump of aggressive sabre-rattling, unsettling long-standing diplomatic balances and risking escalation in others’ responses? Or a Trump who ultimately falls well short of campaign promises (or threats), constrained by Congress, advisors and pragmatic reality, a social media phenomenon but with more limited real world impact?
We all have our opinions, but we cannot know, and it seems dangerous to build an investing strategy around a very unpredictable political environment. We can be reasonably confident that at least some stimulative fiscal policy will hit the US economy, a mix of tax cuts and infrastructure spending, and that it’s likely to boost growth and inflation.
Markets may fall into the trap of expecting too much too soon, but any policy change at all is likely to stimulate the US economy, at least in the short-term, and accelerate the rise in inflation that’s already playing out. It’s not an appealing prospect for US Treasuries.
President Trump’s potential actions may have deep implications for Asian economies and markets, with the threat of tariffs or trade wars (or even, in an extreme scenario, a damaging escalation over Taiwan); then again, a lack of damaging action by the President leaves the way for those markets to continue rallying, driven by a recovering trade cycle. It’s not clear to us that markets are adequately pricing these risks – we prefer to step aside until we have a clearer view of Trump’s approach.Europe faces obvious and daunting political risks of its own. Next year sees major elections in France, Germany, the Netherlands and most likely Italy. We can expect populists to do well at the expense of the mainstream, as we’ve seen in the US and UK. This is likely to lead to nervous moments ahead – after all, some populist platforms in Europe call for withdrawal from the Euro. The departure of a major Eurozone member could fatally undermine the single currency.
While investors may not be fully pricing in political risk in Asia, they appear to be doing so in Europe – perhaps overly so. European equities trade on cheap valuations, especially Eurozone banks; the Euro is at decade lows vs the US Dollar, fast approaching parity; wand Italian 10yr bonds offer yields 1 ½% higher than German, a reflection not so much of the risk that Italy defaults, but the risk that Italy repays those bonds in a devalued, post-Euro Lire.
Markets can dramatically misjudge the risks of a Eurozone disaster, opening opportunities for investors.
Populists will do well in Europe, but we must be cautious of extrapolating our interpretations of that too far towards a Euro-apocalypse. Proportional representation and the need for coalitions will make it hard for far right parties to enter government, and even if we see a surprise win for Madame Le Pen in France, it’s far from clear her desired referendum on the Euro would make it through Parliament.
We have seen before that markets can dramatically misjudge the risks of a Eurozone disaster, opening opportunities for investors: we found just such an opportunity in Spanish and Italian government bonds in the wake of the Eurozone crisis in 2012, when markets panicked about the (in our view highly unlikely) possibility of a Eurozone break-up.
Investors’ attitude to political risk can play out in surprising ways: caution ahead of risky but known events (such as elections) may be entirely justified, but if investors in aggregate are excessively cautious ahead of such events, the results can be surprising. A minority of investors expected a Trump win in November; even fewer would have expected a Trump win to be accompanied by a strong market rally. More investors expected Renzi to lose his constitutional referendum in Italy, but very few would have expected that political setback to be followed by a sharp rebound in Eurozone equities, with banks – the epicentre of Eurozone risk – to be at the forefront.
Investors’ attitude to political risk can play out in surprising ways: caution ahead of risky but known events (such as elections) may be entirely justified, but if investors in aggregate are excessively cautious ahead of such events, the results can be surprising.
This is not to say that political risk doesn’t matter; it clearly does. Rather, it’s to illustrate that political risk must be considered in conjunction with investors’ preparedness and positioning for it. It’s relatively easy to prepare portfolios for a scheduled event like an election, and many investors do so: trimming equities, building cash, buying portfolio hedges. Sometimes that can mean that investors are so well-prepared that the risk, when it materialises, no longer has the power to cause panic and investors are able to buy on any momentary market setback. The current investor attitude to Europe carries these hallmarks. Let’s not forget – much of the Eurozone economy is doing quite well, corporate earnings appear to be growing, and political developments have scope to surprise on the upside too: a President Fillon (perhaps the most realistic outcome) with a programme of reform and restructuring could energise market sentiment towards France, whose economy has lagged the recovery elsewhere in Europe.
So what does this mean for portfolios? We prefer to shift our focus towards areas where risk is well understood by the consensus and largely priced in, and to markets where political risk is likely to have less impact. That means tilting equity exposure away from China and the Asian trading nations, where geo-political risk appears not to be priced in by a market which doesn’t really believe that President Trump will take disruptive steps; and back towards Europe, where political risks are meaningful but are reflected in cheap valuations and very conservative investor positioning. To Japan, which appears isolated from President Trump’s trade-war rhetoric, and perhaps to India, a fast-growing but relatively closed economy, less sensitive to global trade flows.
It means continuing to rotate our US equity exposure away from the large cap multi-nationals that depend on a globalised supply chain, towards domestically focused small-caps, which will benefit from stronger growth at home. It means maintaining an exposure to emerging market bonds, where high yields and depressed currencies show that investors are extremely focused on political risk. But it also means building up our allocations to alternative strategies that are relatively uncorrelated to mainstream asset classes and the economic cycles that drive them. As well as holding appropriate assets and protection strategies that can help portfolios in the extremes, in case political shocks really start to matter more for markets.
Deputy Chief Investment Officer
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