The second stage of our investment process, the understanding of Why prices deviate from their fundamental values, helps us navigate the influential waves of macro themes and geopolitical risks. Several of these macro risks reflect the new populist reality across the globe and have had tangible short-term impact on the markets and may cause significant longer-term consequences on the investing environment:
- U.S. elections
- Italian referendum
- European Central Bank (ECB) meeting in December
- Bank of Japan (BOJ) meeting in November
The important thing is to not make decisions in the heat of battle but to have discussed how to best handle these potential outcomes before they occur so that you can be more objective.
We are analyzing a number of scenarios and potential outcomes and discussing what strategies we may execute in the event of each of those outcomes. The important thing is to not make decisions in the heat of battle but to have discussed how to best handle these potential outcomes before they occur so that you can be more objective.
I believe we were appropriately positioned heading into the U.S. elections. Similar to the Brexit vote, the U.S. elections presented binary outcomes for the markets. While a Hillary Clinton win was our base-case scenario, we did not discount a Donald Trump victory, which created the potential for significant market volatility. Thus, we used options to seek protection in our market exposures.
Uncertainty now reigns, given the policy and institutional ambiguity that a Trump administration presents. I’m sure there will be fireworks in the months ahead, and we will continue to monitor and assess the risks and opportunities. We are primarily focused on the team that Trump puts together as well as the foreign leaders with whom he meets prior to the inauguration. Read our initial thinking on the post-election investment implications (see the Dynamic Allocation Strategies Team Insights at the bottom of the post).
From a European perspective, the Italian referendum in December is a major event, given Italian Prime Minister Matteo Renzi has, in effect, made it a referendum on him. The referendum includes reforms that are designed to increase governmental stability in Italy by improving some election laws and making the senate less powerful.
However, Renzi has associated himself with these largely popular reforms by saying that he will step down if the referendum is rejected. By making it personal, he has altered the decision voters will make. Should Renzi resign, Italy will be thrust into another period of political uncertainty, which is the last thing Italy—and Europe—needs right now.
The significance of this referendum has caused us to be very cautious with respect to our exposure to Italian equities. Even though Italian equities are significantly undervalued, we have decided not to step into this market while this situation plays out.
The ECB meeting in December is another important event we’re assessing. The ECB will be communicating the direction of policy, which may include lowering rates, extending its quantitative easing (QE) program, and trying to steepen the yield curve.
We’re discussing all these options and how they may influence markets and currencies. As we’ve discussed previously, the ECB is under market and political pressure to communicate how and when they’ll start tapering their QE bond buying program.
Bank of Japan Meeting
The Bank of Japan (BOJ) meeting in November was significant as well. They have been really pushing their quantitative easing and other monetary policies into experimental territory. Keep in mind, that the BOJ is not only buying sort-term sovereigns, but it’s also buying long-term sovereigns, credit, and equities, so, it’s influencing these securities both indirectly and directly.
Part of the quantitative measures involves targeting certain rates along their bond yield curve and doing whatever it takes to get there. This means that Japanese bond yields are pinned in a relatively tight range and are likely to be less volatile than other developed sovereigns. This was seen in the post-U.S. election bond sell-off as Japanese bonds held up relatively well. This is one of the primary reasons why we have a preference to be slightly long Japanese bonds, while being short European sovereigns.
The global swing towards populist outcomes continues with the U.S. presidential election result. This result strengthens the power of the United Kingdom within our European Union (EU) game theater. The U.K. is relatively insulated from this populist wave given populism has already taken hold via the Brexit referendum.
The result in the U.S. also puts leaders in France and Germany, where general elections will take place next year, on the defensive from populist parties—now again on the rise—in their respective countries. We anticipate a more difficult Brexit negotiation process despite mutually beneficial outcomes of an amicable affair. This leads to heightened risks across the region during the negotiation process as well as the lead-up to the general elections.
Several of these short-term events are being driven by a major macro theme—populism—that may have long-term impact on the markets.
“You can avoid reality, but you cannot avoid the consequences of avoiding reality.”
– Ayn Rand, a well-known Russian-American novelist
There’s a great quote by Ayn Rand, a well-known Russian-American novelist, that accurately sums up the worldwide populist movements we’re seeing: “You can avoid reality, but you cannot avoid the consequences of avoiding reality.”
It strikes me that many politicians and policy makers have avoided reality, and they are finding out now that they can’t avoid the consequences of avoiding reality. As a result, I believe we will see a lot of behavioral shifts.
In the United States, for example, Trump’s victory may have lasting implications for the Republican party platform, as well as how future elections and campaigns are run. And the EU is no longer preordained. The U.K. has pulled out and there may be strong incentives for other countries to do the same. It seems like populist movements across Europe are saying that they don’t want an unelected body in Brussels telling them what their sovereign nation should do. That probably means that these central state players will become more accommodative.
So, as the establishment begins to realize the consequences of this new populist reality, we believe that they will slowly begin to become more accommodative—kind of like the tide that drives long-term fundamental value. The tides are still there, but the short-term waves, however, are going to be quite large, and those are what we are seeking to navigate in order to take advantage as they happen.