Why are political risks so uniquely problematic? After all, economic prognostication isn’t at all easy; even with the best analysis of the most reliable statistics our ability to predict financial market performance is, at best, mixed.
Individual and collective influence
Political risks bother me a lot for two reasons. First, the outcome of a political process necessarily depends on the actions of a relatively small number of individuals. Our behavioural finance team continually reminds me that the average assessment of a situation by a large group of people is usually closer to correct than the perceptions of an individual or a small group. And it is easier to predict the average behaviour of a large number of people than what an individual or a small group will decide to do.
But when trying to assess what a public entity is likely to decide we are necessarily dealing with a relatively small number of individuals – the US has only one President and the Bank of England Monetary Policy Committee has only nine members – each with their own intellectual and ideological predispositions, blind spots, depth of understanding, wisdom, foolishness, etc.
So assessing how a political process will work out involves making predictions about how some extremely high-powered and complex individuals are likely to react to a wide range of contingencies. I find this kind of analysis especially daunting.
The second reason why political risks are particularly problematic is that what politicians say has a complicated relationship with what they mean. It’s not that politicians lie, although that has been known to happen from time to time. What I mean here is that politicians often say things for effect. Suppose a political leader engaged in a political process says: “If you do X, I will do Y.”
This may be a reliable basis for predicting the politician’s behaviour under defined circumstances. Or it might mean that the politician is keeping his or her options open but wants us to think that if X happens, he or she will do Y to increase or decrease the likelihood that X will occur. Politicians are manipulative.
This is not a criticism; it is a job description.
Interpreting politician-speak
The problem from the point of view of investment strategy is that, if my investment decisions depend on whether a politician does one thing or another, I certainly want to know whether “if X, then Y” is a firm commitment or a negotiating ploy; the more skilled the politician, the harder it is to tell.
So this is why the current investment situation is particularly difficult to evaluate. Within the European monetary union a relatively small number of individuals, operating within highly-charged situations with very high stakes on the outcome, will be called upon to act in a way that either preserves the common currency or risks the repercussions of a break-up.
Under these circumstances assertions that the eurozone banking system could withstand a Greek exit without excessive damage might be taken as a reassuring assessment but also might simply be intended to signal to the Greek electorate that their bargaining power vis-à-vis the rest of the currency union is limited.
In the US to avoid a default on Treasury obligations Congress and the White House will have to reach an agreement to raise the debt ceiling some time later this year. Should we take House of Representatives Speaker John Boehner’s insistence on dollar-for-dollar matching of additional borrowing authority with new spending cuts as political posturing or as a serious credit risk for US Treasury bondholders?
Clear answers to these and related questions would certainly help inform good investment decisions. But we are unlikely to get clear answers any time soon.
The ‘hard’ economic evidence we’ve been seeing should encourage prudent risk taking; the ‘soft’ political considerations might work out positively or negatively. So our basic outlook for the next 12 months is, as it has been, cautiously optimistic.
But in the near term the upside and downside risks the market faces are largely political and, therefore, particularly difficult to evaluate. Hence, we’ve concluded that investors are well advised to reduce portfolio risk modestly – and briefly – until some of the outstanding public policy issues have been resolved one way or the other.
