Unless politicians can offer certain solutions, says Guy Monson, markets will continue to be roiled
LAST YEAR WAS a time when politics determined investors’ fortunes to a rarely seen degree. In Europe and the US, tough but manageable budgetary decisions were delayed or derailed by political impasse, which damaged investor and business confidence, even in regions far from the epicentre of the crises. The rush to hold ‘risk-free’ assets has kept global equities valuations at extreme discounts to cash or government bonds and triggered one of the sharpest falls in European equities relative to their US counterparts in recent market history.
Fundamental economic analysis (supported by longer-term investment themes) would normally have delivered investment out-performance. Instead, extreme political and policy uncertainty made it a difficult year.
Our emphasis at Sarasin on solid income growth in corporate bonds and cash-flow-rich equities was challenged by surging gilt prices, while our reliance on long-term themes backed by demographic trends was lost in the political noise. We are not changing our goals in 2012, but our New Year’s resolution was clear: manage the risks and opportunities created by political tension and policy uncertainty more actively, and work harder to anticipate the investment flows they will generate.
In economic terms, last year turned out broadly as we had projected: a modest but increasingly visible economic recovery in the US, set against a ‘managed’ slowdown in China, as the vast property and investment bubbles of the past five years begin to deflate. Corporate profits and dividends from cash-rich blue-chips around the world remained robust — much as we had hoped — while G7 interest rates look set to remain close to zero for fear that any increase would effectively bankrupt their highly indebted governments.
The political challenges started to mount in the summer, following deadlock in Congress over raising the US’s debt ceiling. Markets had assumed that a bipartisan approach would be hammered out, but they were unprepared for the fanatical nature of many Tea Party-sponsored Republicans. In the end some degree of common sense prevailed, but not before US debt was downgraded, risk assets fell and funds flowed into ‘safe assets’ (ironically, newly downgraded US Treasuries).
Similar political indecision turned peripheral Europe into a global financial crisis threatening at times to dwarf the credit crisis of 2008 in magnitude. Its severity is all the more surprising, because most of the world’s leading economists had already concluded months earlier that either a United States of Europe becomes a reality (with jointly issued European bonds, ECB sovereign support and common fiscal policies), or the euro starts to break up, with a series of disorderly defaults in the peripheral nations. We were prepared for both possible outcomes, but believed the political desire to hold Europe together would ultimately favour the former. While we may still be right, it has been difficult to foresee the damage that this agonising ‘muddle-through’ could have on investor flows to the region.
In the event, US funds led a wholesale drive to sell or withdraw assets from ‘European’ institutions, triggering a liquidity crisis across euro area banks and driving the euro to a 16-month low against the dollar and a lifetime low against the yen. For equities, the result was one of the widest divergences in geographic returns in a single year: French and German markets saw falls of 17 per cent and 15 per cent, while US stocks actually ended the year up.
A SIMILAR TRIUMPH of politics or perhaps ‘policy’ over economics has played out in world bond markets. Central banks are acting to deliberately suppress not only short interest rates, but also longer dated bond yields. Quantitative easing remains at the heart of domestically focused monetary policy in the UK and in the US, where a third round of housing-focused QE is possible if the economy stalls. Foreign-exchange intervention is being deployed in Japan, much of the rest of Asia and Switzerland, while in Europe political hostility to direct sovereign bond purchases has led ECB governor Mario Draghi to channel central bank liquidity directly to European financial institutions.
These are radical, often politically vulnerable monetary tools, whose policy outcomes are uncertain as they are rarely used. Again, political and policy uncertainty has driven investors to switch to the least risky assets (the gilts or Treasuries that central banks themselves are buying), even if real yields are substantially negative.
Our New Year’s resolution was to incorporate more measured and sophisticated political analysis into our investment strategy, to match the depth of our economic thinking. While we will strive to use this to improve our investment timing, our core strategy remains unchanged — cash-flow-rich global equities tied to the new politics of austerity, efficiency and thrift, are still our preferred asset class.
Guy Monson is CIO and managing partner of Sarasin and Partners