Sound Money

This article originally appeared in the 20 October version of finweek:

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Political awareness has exploded in 2016 after Brexit sent shockwaves through financial markets. Yes, the UK economy will survive and financial markets have recovered post the decision but the UK has been set on a completely different political trajectory. In this instance politics dictated investment performance and the decision could still shape the future of Euro area.

Bookmakers and many money managers argue that Brexit was a 6 sigma “completely unexpected” event that happens once a decade. If this is true then we can put any potential relationship between politics and investments to one side. But what if Brexit, Trump, anti-immigration in Europe and the Economic Freedom Fighters in SA signal a trend in socioeconomics that have found expression in populism? If this is the case politics could be an increasingly important determinant of investment returns. Perhaps we require a greater understanding of the potential relationship and an appreciation of what strategies work under volatile political conditions in order to generate returns and protect capital.

Populist politicians find their voice

Some might argue that my political fears are merely a bias towards recent information and fear mongering amongst the media. However the number of extreme political parties with tangible power in their grasp is unprecedented in the last 50 years. The radical left-wing Syriza is in power in Greece. In Spain extreme leftists have garnered a third of votes in the 2016 elections. In France and the Netherlands extreme right wing parties are leading the polls ahead of their 2017 elections, both with a strong anti-immigration stance. It’s not just a European phenomenon. In the US Bernie Sanders won significant support in the primaries by offering radically socialist values relative to the Democrat establishment, while Donald Trump appeals to a segment of the working class voters due to his “say-it-as-it-is” anti-establishment brand. Right or left, what all these movements have in common is populism, appealing to the fears of disgruntled voters in their respective countries.

The Brexit vote was complex but it’s difficult to deny that anti-immigration populism became a central pillar of the campaign as voting day neared in a desperate attempt by the “leave campaign” to appeal to working class voters who were fearful in light of the recent European refugee crisis.

The economy is not providing opportunities

Voters feel fundamentally disenfranchised by the economy. And rightly so. Whether the solutions being offered by the populists on either side of the proverbial political aisle will work is beside the point. Global economic growth remains pitiful post the Global Financial Crisis and it isn’t providing social mobility opportunities. The US is often applauded in economic circles because it is outperforming most of the developed world but even the world’s biggest economy is only growing slightly above 1% per annum. This comes after dropping interest rates to zero and flooding financial markets with $3.5tn worth of liquidity via Quantitative Easing (QE). 1% real GDP growth is well below the long-term US average and closer to a recession than “normal” economic conditions. In South Africa we have narrowly danced with a technical Gross Domestic Product (GDP) recession for a number of quarters. The economy has hardly gone anywhere during this period and SA has bled jobs, leading to increasing levels of economic distrust.

Monetary activism by the major global central banks in response to the Global Financial Crisis (GFC) only intensifies this distrust. QE inflation found its way into asset prices where educated professionals easily profit through equity, pension and property holdings. On the other hand, the poor have suffered with rising food prices and anaemic social mobility, which has resulted in rising inequality.

Political populism festers during periods of weak economic growth and intensification of both of these trends over the past year should give us pause to reflect before the trend is cast in stone. History tells us that the worst socio-economic disasters usually happen when extremist politicians take advantage during troubled economic times to prey on the fears of the masses: Stalin in Russia after the fall of the Tzar and Hitler in Germany after the post WW1 debt reparations are the clearest examples. Current political leaders are equivalent to the extremities of Hitler or Stalin but falling interest rates in the world’s major economies and rising aggregate debt levels eerily mirror the troubled times of the 1920’s and 1930’s.

What can be done to arrest the trend? Growth policy deja vu

The G20, IMF, Federal Reserve and World Bank tell us that further lower interest rates, higher inflation and greater debt funded aggregate expenditure are required to pull the globe out of the current mire. It is possible that they are correct. However it is easy to see from the chart above that this plan has been tried before.

Interest rates are already at multi-decade lows across the globe and are zero in some places, which provides the perverse signal that there is no time preference between current and future consumption. It is no surprise then than aggregate debt levels are at multi-decade highs.

Just like a student who forgoes future consumption in the early years of professional life to purchase a university education in the present, nationwide debt accumulation is merely a decision to forgo future consumption in order to consume in the present. If the debt isn’t put to productive enough use (fancy clothing instead of education), we reach the future and earnings haven’t progressed sufficiently to offset the loan repayment and consumption must be reduced.

The future is here. The globe has clearly made some bad investments otherwise we would have repaid rather than exploded the debt stock. Lower consumption is the current economic truth we’re digesting. Many main-stream analysts dogmatically ignore this economic truth and remain hopeful governments can paper over the cracks but the risk is that more debt will merely prolong the pain.

Over reliance on “consensus” is dangerous

One reason for the ineffectiveness of market or bookmaker prediction models is the bounded rationality of main-stream analysts who cannot fathom why voters could choose an outcome so contrary to the analysts own status quo world view. However the majority of voters might hold a completely different worldview, seeing the political and economic status quo as their key obstacle.

Contrarian’s profit from the status quo

While the consensus analysts were puzzled by the Brexit, the best performing managers during the Brexit period were the contrarian style investors. Contrarian’s don’t necessarily need to take a strong political stance between two opposing candidates. They merely question the orthodoxy and have an ability to envisage non-standard outcomes. Contrarian’s also position portfolio’s to take advantage of asymmetric events like Brexit.

With developed market interest rates at historic lows the cost of option strategies, which benefit from asymmetries, is incredibly low. Volatility has been suppressed by low interest rates and is a critical input in option pricing. For example, volatility on US equities (as measured by the VIX) has only been lower 2% of the time through history. The payoff from asymmetric events is usually handsome as the market quickly moves to price additional risk premia into European banks, for example. If political populism continues to respond to weak levels of economic opportunity then these handsome payoffs might become more regular than the market is currently pricing.

Political appreciation is an increasingly important determinant of investment returns

It is a cop out to say that investments are merely at the whim of politics when it is possible that poor economics are the root cause of increasing populism. As custodians of client’s wealth investment managers must be able to question the status quo and interrogate whether there is a relationship between investments, politics and economic conditions. Sitting on the side-lines and enjoying the fruits of low interest rates without considering the costs is imprudent. Brexit was interpreted as a 6 sigma shock by many investment professionals. But what if disenfranchised voters vote for Trump in the US or Le Pen in France next year? Should we be surprised? Unsustainable economics has come full circle to encourage unsustainable politics. Investors should be acutely aware of these risks and positioned accordingly.