Fiscal cliffs and eurozone crises – investment managers need to understand politics too.

27th December 2012

 

The US appears to be hurtling towards the fiscal cliff again. That cliff is a series of tax rises including the end of some temporary Bush-era tax cuts  – amounting to just about the same thing – and spending cuts.

By pre-legislating for these changes, America’s intensely divided politicians have effectively set themselves a big deadline by which to agree a compromise or face a huge hit to gross domestic product. This is calculated by the Congressional Budget Office at around 4 per cent in 2013.

A four per cent hit to GDP is something that America and the rest of the world including the UK could certainly do without. In fact, it would be pretty disastrous during a period of economic growth let alone during a fragile recovery. 

Barack Obama has cut short his Hawaiian Christmas holiday as the BBC reports to meet with Republican Congressional leaders.

For what it is worth the US Treasury has a plan B outlining the ‘extraordinary’ measures it will take to give the US and the world a little breathing space possibly for up to two months past the new year. That includes cutting certain federal assistance to US states and cities, halting investments in federal securities by those states and municipalities and calling on an emergency fund intended to defend the dollar in times of duress. 

Treasury secretary Tim Geithner has warned that without these measures the US would be in default by Monday taking the world into completely uncharted economic territory where the country behind the world’s reserve currency defaults. 

For those who want to know more about how on earth the world’s most important economy tied itself in such economic and political knots, this is a rather brilliant backgrounder about the fiscal cliff on the website of the US Council on Foreign Relations.

But at Mindful Money, we think all this turmoil carries an interesting lesson for investors – that political risk is likely to remain a big threat to economic prospects and, to a slightly lesser extent, investment prospects in 2013.

For much of 2012, the day to day stock market price did not just move on the big economic and significant company news. It also depended on the state of the debate about the fiscal cliff and the debt ceiling in the US, the endless Eurozone summits, speeches, agreements and disagreements and even the accession of a new generation of political leaders in China. Political risk if it ever went away has come back with a vengeance.

There isn’t a very easy way to play this in investment terms unless perhaps you focus on currency trades or other short term bets. For example, it is very difficult to know exactly how US pharma or defence stocks may fair while politicians horse trade while if there has been broad agreement on a certain provision it has usually been priced in. 

However given recent events, investors might well ask themselves why on earth did markets and maybe even some fund managers get so confident that a deal would be struck before Christmas?

To put it another way, the relatively moderate Republican leader in the House of Representatives John Boehner appeared to have outlined a compromise with the President in mid December prompting global markets including the FTSE100 to come as close they can to jumping for joy. However those markets also failed to recognise that the House in particular contains a huge number of Tea Party-backed Republican members some of whom have pledged never to increase taxes and who are also unsurprisingly defence hawks. This meant they were completely ideologically opposed to two measures in the outlined deal because the compromise would have seen big defence cuts and tax increases even if only for millionaires. It may also be worth noting that the most recent one-term Republican President lost the Whitehouse partly for reneging on his slogan 'read my lips, no new taxes'.

Perhaps market traders don't know much political history, but to many political observers disagreement is not just back on the agenda – it was probably never really off it.

Now of course, these are markets we are talking about. They are defined by millions of different decisions which are not necessarily rational certainly not over short periods of time.

Fund managers and asset allocators however are individuals whom investors can identify. In the last few years, they have been beefing up their analytical skills aiming to acquire a better understanding of politics along with the ability to read the more traditional economic signals.

It strikes Mindful Money that this is more art than science but it certainly doesn’t mean ignoring political issues. We think investors may need to start asking about this skill set more often. Perhaps not quite as blunt as “Does the person who helps me construct my portfolio know whether the President and Republicans will stop the US falling off the cliff?” Frankly no-one knows that.

But if they can assess and set out the balance of risks and what it may mean for markets, assets and portfolios in the short, medium and long term, then they may be demonstrating they have the skills to run your money more effectively. 

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