Markets on edge while stupidity prevails
Markets dislike dysfunction in Washington, and react with relief when politicians opt not to do something stupid. But measuring the risk of political stupidity is impossible.
October 12, 2013 / 17:22 IST
When investment managers blame politicians, it is usually an excuse. What politicians decide will rightly not always be in the short term interests of people playing the markets. Investors should just get on with it.
But this time is different. Investors have good reason to complain about their elected representatives.The two best days for the S&P 500 index this year were January 2, when it rose 2.5 per cent after Congress thrashed out a resolution to the "fiscal cliff" issue, and Thursday of this week, when it rose 2.2 percent after news that Republicans in the House were asking the president to agree to a temporary six-week rise in the "debt ceiling" - which would postpone a possible default.More News From Financial Times
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The pattern is clear. Markets dislike dysfunction in Washington, and react with relief when politicians opt not to do something stupid. But measuring the risk of political stupidity is impossible. You need to put a price on the damage that would be done by a default for securities treated by the rest of the planet as truly risk-free. This has no precedent. It also requires putting odds on the chance that it would happen, which requires access to the inner thoughts of many dozens of politicians.Models based on market trends, or economic or corporate data, cannot predict whether politicians will do something dumb. Pricing risk, speculative at the best of times, descends into total guesswork. Judging by the yields on treasury bills that mature in the next few weeks, people took the prospect of default seriously, but still rated it very low. As for stocks, this has been a great year for the S&P, which was only slightly below its all-time high after two weeks of grinding speculation about a sovereign default. While default is perceived as a risk, but only a small one. This is a post-Lehman phenomenon. The Lehman disaster showed that political common sense cannot be taken as given, and that gross policy mistakes can happen.This was shown not only by the decision not to rescue Lehman, but also by the subsequent vote by Congress not to authorise the $700bn "Tarp" rescue plan for the banks - which, when implemented, proved to be the critical step in allowing the bank system to recover from the crisis. Neither decision was as self-defeating as a vote to force a US default would be. But they changed perceptions of political risk. Before Lehman, this risk was underestimated by the markets. Now it is arguably overstated. It is not only politicians who markets find it hard to second-guess. They also have trouble predicting the actions of voters - or at least how votes will be refracted through the political systems of different countries.In the US, polls show that most voters believe that the deficit is rising, when in fact it has halved over the past five years. This makes their attitude to the debt stand-off harder to predict.Meanwhile in Europe, the eurozone's sovereign debt crisis has been in abeyance for more than a year. It has always been primarily a political crisis. There is enough money in the eurozone to pay off all the countries' debts. The issue has been the political one of distributing pain. The assumption of those betting against the debt of countries like Greece or Italy was that the politics would be unresolvable.Either wealthier nations like Germany would balk at the bill. Or the poorer nations would balk at the austerity required of them.So far, neither has happened. Elections in Italy and Greece produced huge protest votes, and parliaments that agreed on continuing with austerity, thanks in large part to the quirks of their proportional representation systems. Street protests have been widespread. But even with unemployment rates far in excess of 20 per cent in Spain and Greece, mainstream parties remain in control, implementing policies in line with the eurozone's wishes.In such an environment, investors need to know political science and sociology as much as economics or finance. Broadly, markets have underestimated the power of the status quo to keep on an even keel, even against the wishes of most of the population. As it has dawned that Europe might weather the storm without popular insurrection, money has flowed back into European assets. In the US, the opposite is true. Its constitutional system of checks and balances has worked well for two centuries. But now it seems capable of forcing an unnecessary default. On balance of probability, the US will get through this. A messy compromise will be reached. With earnings season off to a good start, and earnings projected to rise at a decent annual clip of 4.5 per cent, that means that on balance of probability stocks are due another leg up, once some definitive deal on the US debt has been reached. But this is only on balance of probability. For now, there remains a risk that stupidity will prevail. While that risk remains, managing money is hard. Investors who complain about politicians are fully entitled to do so. Discover the latest Business News, Sensex, and Nifty updates. Obtain Personal Finance insights, tax queries, and expert opinions on Moneycontrol or download the Moneycontrol App to stay updated!
