Investors who base asset choices simply on economic data could be making faulty decisions over the balance of risk and reward, according to one fund group, which views the global political outlook as increasingly unstable. Potential sources of risk include regime changes and even, some fear, a major war. Kira Nickerson investigates
Economic data is too shallow of an analysis of market trends and geographic risk/rewards, according to Hermes Fund Managers. Today’s world is heavily influenced by the political stage – in both developed and emerging nations – and understanding the implications of political actions, is key to assessing value in asset classes and markets, the group asserts.
In a paper published this autumn Hermes chief executive officer and head of investment, Saker Nusseibeh, notes it has been at least two generations since investors actively looked at the problem of political risk in the context of developed markets.“They need to start.”
“Today, growing unrest brought on by anger over austerity, worries about resource scarcity and threats of increased taxation has refocused attention on national problems as opposed to international concerns. In such an environment politics can have as much impact on the attractiveness of different markets as GDP figures,”he says.
Keith Wade, the chief economist at Schroders, says the long period of political stability in the West has perhaps made investors complacent as to the risks it can pose and that the situation today is merely a return to normality.
Nusseibeh says it is, noting that in the history of developed markets political risk was once quite prevalent but faded as an investment consideration post World War II. He and Wade agree the presence of the Cold War played a part in creating such stability as it polarized developed nations and allowed them to focus their attention on common threats. Since its end and the subsequent onset of the global financial crisis, more nationalistic interests have arisen.
Andrew Parry, Hermes Sourcecap, observes:“Economic strife can and does bring, historically, a whole legion of tensions. Recovery requires a long period and political intervention is necessary. Unfortunately, the steps needed do not necessarily sit comfortably with election cycles. Welcome to the political economy.”
The European crisis may be a prime example of a step up in national interests and tension, but it is not the only political field managers have to watch, nor is sovereign debt the only asset class that is affected. Political events in China, the US as well as those in the Africa and the Middle East are all front-page news these days, impacting a range of asset classes to varying degrees.
Commodity prices are the obvious fall out from Middle Eastern conflicts but there is also the rise of gold owing to the uncertain climate; downtrodden financials are being affected by stiffer regulations; real estate investments are focused on safe haven regions; and Capital expenditure spending of companies in some countries is hampered by uncertainty over the prevailing and potentially changing tax climate. Consumers, worried over the state of unemployment and disgruntled over respective home politics, remain unconvinced of market opportunities and reluctant to invest.
James Bateman, the head of manager selection at Fidelity Investments, says investors remain inherently nervous, with the scars from the events of 2008 a long way from healing. This has led to a greater emphasis on the analysis of risks, including geopolitical ones.
Nusseibeh adds:“Some may argue the much heralded era of globalisation minimises political influence on a stock or securities selection basis. Not necessarily. As national interests and protectionism increase, this will have significant impact on companies and corporate interests.
“Also, consider the debt levels of many countries compared to the strength of corporate balance sheets. How long will indebted nations allow companies to reap such profits without taking more of the pie for themselves? Will they tax the companies or the shareholders? What if political change affects the way companies pay dividends?”
Threat of war?
Charles Nenner, the founder of an institute examining market cycles and until 2008 an employee at Goldman Sachs, notes military conflicts tend to rise when market cycles are at the bottom, as they are today. “Good things do not happen when the cycle is down and yes, we are in a bad period,” he says, pointing out such a time is likely to last until 2020 and there is a high probability of war occurring before this cycle ends.
In 1985 the author Richard Hoskins wrote about war and peace cycles. Going back some 4,000 years he purported that every major war, financial panic, economic depression in history can be traced to issues with usury banking. According to some commentators, based on his thesis we are currently in a war cycle.
So are we in for a war? Some believe it is possible although exactly where remains a question mark. Many investors are inured to tensions in the Middle East, although heightened recently as evidenced by the Arab Spring, likewise wars and coups in many emerging markets are something to which the world is accustomed.
However, what about a conflict or even war between developed nations? The risk may not be as minor as may have been assumed a few years ago. There is growing tension within Europe; a worrying level of posturing between Israel and Iran; with its mounting debt concerns the US ‘empire’ is waning; and China and Japan are in a tug-of-war over disputed islands.
Hermes’ Neil Williams, cites Spain as a prime example, where its government is between a rock and a hard place. If its politicians do not implement needed reforms, downgrades are inevitable and its economy will struggle even more. However, if the Spanish government does implement deeper austerity measures such actions could lead to greater social unrest.
He says: “High youth unemployment, which is at 54 per cent in Spain, is typically one of the two main ingredients for civil war (the other historically is bad harvests). While we are not suggesting war is likely to break out, it does highlight the difficult situation for Spain’s politicians.”
Nusseibeh says: “The idea of war between developed nations in modern times may seem absurd yet it is not that far fetched. Do not forget that for most of modern history these nations have gone to war over economics. Considering today’s growing wealth divide, both between countries and within them, it is entirely possible that at some stage some will say ‘enough’ and seek forcible change.”
As for emerging markets, there is the heightened situation between Turkey and Syria while oil fields located in the middle of North and South Sudan have created disputes that have already manifested into armed conflicts.
The impact of such conflicts on oil prices is already disquieting. Colin O’Shea, Hermes Commodities, says: “If we had projected the potential of something happening on a scale of 1-10 over the past 20 years, other tension-riddled periods would maybe have rated 5-6; today we rate the probability of something happening around 8-9.”
With heightened political concerns, elections have become a point of focus for many investment managers. With the elections of Greece and France now behind us, at the moment the most intensely watched events are the 6 November US election followed by China’s leadership transition (announced next month but taking place in 2013).
While the investment world has always tended to pay attention to the US election, the choice between existing Democratic president Barack Obama and Republican Mitt Romney seems even more vital considering the US debt situation.
James Abate, the manager of PSigma American fund, has assigned a 15 per cent probability Obama will be re-elected, the House will go Democratic and the Senate will stay Democratic; he awards a 50 per cent chance to the election resulting in the status quo, with the House and Senate staying Republican; while there is a 35 per cent chance Romney will be elected and everything is controlled by the Republicans.
The middle scenario appears to be the consensus view, Abate says, and it may be a helpful outcome for the US. As the president can only sit two terms Obama would be ‘freed’ to govern without re-election consequences.
“There is a recognition that certain things need to get done or there is a real risk the US will go the way of Spain. In this scenario reforms that need to happen are likely to do so,”says Abate
Wade is also watching the US election closely. The so-called fiscal cliff the US is facing in the New Year is a worry, as is what the new president may do with regards to taxation. Tax increases will automatically be enacted unless the new president takes action before 2 January – leaving a small window for whoever is elected.
At a recent UBS conference the US election was the centre of discussions as managers debated the investment implications of three main scenarios (see Trends, page 16 for more).
The first being a last-minute deal is struck preserving many, but not all, of the mandatory cuts and tax increases, leading to anaemic 2013 growth, but not recession, UBS managers stated. Scenario 2: Washington decides to delay the pain by continuing most tax breaks and not reducing spending in 2013, pushing the fiscal problems into the future. UBS’s third scenario is no agreement between feuding political parties; the US falls off the fiscal cliff, leading to a government shutdown, widespread uncertainty and a likely recession.
The asset manager says the first scenario is the most likely. Still, Curt Custard, UBS head of global investment solutions, says: “There is almost no doubt that the fiscal cliff — no matter how it’s resolved — will lead to a drag on GDP growth next year. The question is how much, and if there is political will either to move toward fiscal responsibility with lower growth, or to push for growth at the expense of a continuing, unsustainable long-term fiscal position.”
As troubling as the US election is appearing, it is not the only political battle on the horizon the financial world is watching. Elections in far-flung and once less concerning nations are now capturing attention. John Chisholm and Lode Devlaminck, Hermes Global Equities Advisors, note 2012 has been a big political year with elections in France, Greece and Russia with more to come in early 2013. There are elections to watch in Iran, Cuba, Chile, Israel and crucially for the eurozone, Germany to name just a few.
According to Schroders, China’s upcoming political transition, which takes place every 10 years and will be announced on 8 November, is weighing on investor sentiment, delaying investment and spending decisions. Fidelity’s Bateman agrees the wait for change in China has lead to policy inaction and until the new leadership takes over it may be difficult to predict what may occur.
One of the reasons elections are being eyed so closely, even in areas that have not traditionally captured attention, is the knock-on economic implications of new governments. Austerity measures and high unemployment in many western countries are breeding discontentment among the electorate, who in turn are demanding greater change. This leaves elected politicians with a shortened period of political capital to get things done as well as the rise of more extreme political parties.
Nusseibeh says: “Across western countries we are already witnessing the budding sentiment that democratic governments are ruled by a political elite and the wealthy, which disenfranchises the majority. The upsurge of the Tea Party movement in the US and the recent showing of right-wing parties in many European nations is demonstrative of the fact that in times of strife, political extremism grows.”
Investment analysis of politics
Politics are not as easy to analyse as economic figures and this poses a problem for many fund managers. For one, politics requires in-depth understanding of a country that some managers, especially those not based locally, may not have.
Nusseibeh says: “Many asset managers have been attempting to work out the investment scenarios of a continuation or break-up of the euro. However, in order to appreciate the full picture, analysts need to better understand the workings of Germany’s ruling coalition. What are its concerns and motivations?”
Nenner too says it is difficult for asset managers to truly understand the motivations in other regions as their perception is skewed by their own experience and culture. He also argues the relevance of when politics are analysed as political decisions are deemed helpful or unhelpful based on the prevailing sentiment of the time not necessarily on the action itself.
Nusseibeh says asset managers need to start employing political analysts and become as aware of the political landscape in all markets as they are of economics. O’Shea at Hermes Commodities, notes his team continually monitors global political activity, assigning probabilities of events and supply/demand patterns that could alter prices.
O’Shea says: “Our own analysts do the bulk of this work but we also employ geopolitical consultants who help us to stay informed on what politicians are saying globally, the levels of military mobilisation and to monitor bills being passed.”
Wade also cites external sources Schroders has sought input from in order to help its analysts build a more robust picture of the political risks to markets today. Among these are ex-military and even former MI6 agents.
He adds: “Politics are extremely unpredictable. There is a lot of posturing between countries and there is a question of the personalities involved, which makes it difficult to judge.”
Iran and Israel is a case in point as to the difficulties involved in assessing risks based on political maneuvers and rising tension between the two nations. As such, Wade says, he has spoken to people who better understand the dynamics of the region – from diplomats to security personnel.
He says:“It is very useful to get their insight. Along with everyone else we see the headlines but there is more to the story we need to be able to understand so we are tapping into a wide range of expertise so we can prepare a range of scenarios for our funds.”
Bateman says seeking external expertise to aid in assigning outcome probabilities is a common theme among many of the managers Fidelity uses at the moment. Events such as the forthcoming change in Iran and what it will mean does need specialist input, he notes. Another approach he has noticed is the inclination for funds to be positioned in the middle ground during political events such as elections.
“It is dangerous to take too extreme a view. Nothing is certain with politics so the sensible approach is not to bet the house either way – wait for greater certainty and clarity,”he says.
Where to invest in this environment?
Much has been written on the negative views many managers have over western sovereign debt. However, it is not the only asset class affected by the fall out of the financial crisis and escalation in political intervention and influence on markets.
Among the most obvious politically motivated actions impacting investments has been the increase in regulation, especially those targeting financials in light of the 2008 crisis. From banking legislation, Dodd-Frank and FATCA, US actions have extended far beyond its own borders and are impacting banks, hedge funds and retail asset managers globally. Likewise in Europe regulations like Solvency II, Basel III and the AIFM directive are all hitting financials, changing the way they do business and impacting their profitability.
The influence of national interests can also be seen in commodities. Droughts and inclement weather are impacting crops and this in turn affects the supply/demand picture and food prices.
O’Shea notes: “Russia has experienced a dry summer and combined with a growing protectionist stance could restrict wheat exports; the mandated percentage of corn used in ethanol production in the US could be changed as a result of its dry summer.”
Despite such headwinds the political and economic framework of today is creating across markets, managers remain optimistic there are opportunities to be had.
Henderson Eurotrust manager Tim Stevenson says governments across Europe are keen to emphasise pro-growth policies, providing an investor-friendly environment.
He says:“We cannot wait until Europe returns to a more normal situation; we need to take advantage of its new reality and find companies that can flourish in this low growth world. We need to start viewing the situation in Europe as an opportunity, not a threat.”
According to Abate if Obama is re-elected and the House goes Democratic, then the investments likely to best benefit will be those that own tangible assets, companies such as utilities and energy. “However, the market will not do all that well in this environment,” he says.
If the US election turns out to maintain the status quo of today then Abate says it will be a good environment for larger companies. Meanwhile Romney as President and the House and Senate controlled by the Republicans would likely lift all boats and the market as a whole could do well, he adds.
There are safe haven regions many managers appear to agree on, such as Australia, Canada and Norway. Australia appears to be the favourite of many with managers who cite its political stability, the relative benign impact of the financial crisis had on the economy, but most of all its access to commodities.
However, Bateman says the sense he gets from fund managers is that Australia is not a cheap market and many prefer to seek out companies on distressed valuations than paying up for safe havens.
He says:“The pervasive theme is quality. It is not necessarily an asset allocation call but for the macro-minded managers we use, there is a preference for large multinationals that due to their range of economic exposures may have limited downside. Of course they may also have limited upside potential.”
Wade notes the UK is also deemed a safe haven of sorts, an unexpected consequence of the European crisis. Certainly this is evidenced within the property markets, where the past year has seen an increase in overseas buyers entering the UK property market. In the second quarter of 2011 some 58 per ecnt of central London office investments came from overseas investors; at the same point a year later that percentage had risen to 78 per cent.
Gold has been the traditional ‘safe haven’ asset and there is no denying it has had a good run during the global financial crisis. Nenner says it could soon even reach $2,500 an ounce, although not in the immediate future as in the short-term he is less positive on the reserve currency, he adds.
Nusseibeh concludes: “Investors can make money in times of discontent and political struggle; they just have to better understand the risks they may be taking.”