A sentiment very close to IFA Magazine’s editorial philosophy – the politics and the macro issues are shaping the markets (don’t get our Editor Mike Wilson on the topic unless you have a spare few hours..)
Bill McQuaker, Deputy Head of Equities at Henderson Global Investors discusses the re-emergence of politics as an important influence on the financial markets:
Politics as a driving force behind markets appeared to be in the ascendancy during the late 70s and early 80s, decades that saw the rise of political heavyweights such as Margaret Thatcher and Ronald Reagan. As the years went by, however, our leaders and their policies appeared to become increasingly less relevant, until politics became more like ‘background noise’ to investors.
But everything changed in 2008. The turmoil of the Global Financial Crisis produced large-scale interventions on both sides of the Atlantic to bail out the banks, and initially it was thought that these measures would be a ‘one-off’. Quite clearly, that’s not how it’s played out, and we have re-entered a world where markets hang on the utterances of politicians, and investors spend considerable time trying to predict what those in power will do next for their economies. Looking to the past, history may provide us with some indications, or clues as to the sort of developments that might be waiting further down the line in this respect.
The 1930s may provide a good reference point when examining today’s political and economic challenges. To try to bring his country out of the Great Depression, Franklin D. Roosevelt (FDR) chose a path that, by the standards of the day, was extraordinarily radical. Under the Neal Deal, he proposed a multitude of measures that included massive increases in public spending and considerable government intervention in the financial sector to stem the wave of bank failures. It seems that this radical policy was successful: under FDR, the US experienced compound annual GDP growth of 8.5%. Naturally, the Second World War was also a significant factor in driving that growth rate, but, nevertheless, the turnaround in output for the US economy based on his vision was stunning.
Moving forward to the 1970s, there was a sense of profound failure about the UK economy. Once again, a politician emerged who was willing to entertain some radical notions about what needed to be done. Thatcherism was an instrumental driving force for UK growth and industry. Admittedly, the government’s policy changes produced some difficult years in the early 1980s, but with hindsight these paved the way for a period of substantial economic expansion and a very strong stock market performance.
So where are we today, and how do we fit our current experience into this historical context? I believe that, in tackling the current Eurocrisis, there has to date been a distinct lack of creative thinking on the part of politicians and policymakers. Looking to the past, Roosevelt’s revolutionary ideas while unconventional were effective in moving the US economy forward. There have been few signs that European leaders have been thinking outside conventional parameters: their current ‘solutions’ just aren’t working. It is conceivable, however, that at some point in the near future this situation changes, and that someone will come up with an alternative, one that may or may not be palatable to investors.
One of our most interesting observations centres on what is happening is Italy: former leader Silvio Berlusconi has been talking about the ‘European problem’ in a very different language from that of other leaders so far. First of all, far from being ‘dead and buried’, Berlusconi still has a power base in Italy and is trying to address the country’s debt problems in really simple terms. In his view, there are three possible solutions to Italy’s crisis. Option one – Germany bails out Italy; option two – Germany leaves the euro; option three – Italy leaves the euro. Whilst in no way endorsing this view we do observe that radical thoughts such as these are something rarely discussed publicly among mainstream politicians, and may have traction with a restive public. With Italy due to go to the polls in 2013 there is some talk that Mario Monti might not survive until then, and an election might be called earlier. I wonder whether such developments in Italy mean that things are about to start changing in a much more meaningful way.
If not Italy, a challenge to the current order of Europe could perhaps be mounted by Spain or Ireland. Ireland is an interesting case because of the campaign stance that Sinn Fein took last year with regard to the fiscal compact. They said that if Ireland signed up they were effectively ending Irish democracy: they argued that spending decisions would ultimately be taken in core Europe, and that, in this scenario, an Irish government would soon have very little say on what happened in their own country.
It appears that Germany may try to move in incremental steps towards a federal Europe, where, ultimately, there is common issuance of debt. It is very important to consider what Germany might ask in exchange for this, quid pro quo. One assumes that certain powers will be transferred ‘to the centre’. We anticipate further debate amongst Europe’s periphery, and only time will tell as to whether such notions will be entertained or rejected. Discussions have started already, and who knows when the ‘volume’ on those will be turned up.
China is also an interesting area of discussion from a political perspective. Its once in a decade transitioning of leadership has not run very smoothly thus far, with a senior politician having already been arrested – causing Chinese policymakers to be a little more ‘hamstrung’ than they would be usually. China is the second largest economy in the world and the market expects that powerhouse to continue growing at a very rapid rate on a sustained basis. The law of large numbers suggest this is unfeasible: countless times companies have failed to pull that off; it’s equally difficult for a country.
In addition, the US faces presidential elections in November, and, since the US slowdown, Barack Obama has faced increasing criticism. The US Federal Reserve (Fed) historically has eschewed changing monetary policy in the months leading up to a general election. This election already appears to be very tight, and with a slowing economy and a market that has acquired an appetite for a third round of quantitative easing (QE3), one wonders whether the Fed will feel that it has quite the same room for manoeuvre that it had back in 2010-11. The US has been one of the more reliable economies globally over the last few years, but even its growth rate appears uncomfortably slow. Historically, the US has fallen into a recession if the rate of growth drops below 1.5%. This is now at 2%. So, one error – one ‘shock to the system’ as it were – could see the US back in recession. We need to be alert to signs that this could happen.
So, how does one position a portfolio given this challenging political backdrop? Well, it’s important that we focus on identifying factors that determine returns and outcomes over the medium and long term as well as the short term. Over the last few years investors have (perhaps unduly) focused on the short term, partly because of this pick-up in political noise and the unpredictability of government strategy.
Right now we appear to be inhabiting a world where stocks are trading at pretty reasonable valuations. I do not think the equity market is ‘dirt cheap’, but nor do I feel that it’s expensive. From a valuation perspective, we believe it to be a wise course of action to try to avoid short-term noise and focus on what matters for the medium term by applying some risk to portfolios. At the same time, we believe this view is supported by the fact that core government bond yields are at historically low levels, with returns from gilts, treasuries, bonds, and Japanese government bonds in the ten-year group being rather pitiful.
So one option would be to ‘seize the day’ and own risk assets. But I have to say that while that might make sense for some investors, it doesn’t work for everyone: some will struggle with the stresses of ignoring the short-term noise we spoke about earlier. Instead, we propose another strategy. In our multi-manager portfolios, we feel we have a judiciously selective collection of risk assets, but we are also employing some hedges – these currently have a US flavour and incorporate US treasuries, US dollars, and trading volatility in the US market. We’ve also developed a philosophy over recent years that has involved managing the portfolio according to near-term circumstances in risk appetite. It’s a philosophy that has stood us in quite good stead, and one we believe should allow our investors to better sleep at night, particularly given the political dynamics in play at the moment.
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