Many investors remain focused on China growth and oil prices as the biggest risks to global markets. These are certainly significant risks, but we believe that populism, and the potential move toward antitrade policies that comes with it, is the biggest risk to capital markets for the next year or more.
Populism, which stems from a population losing faith and trust in their leadership, can be broadly defined as antiestablishment movements frequently exploited by nontraditional political factions advocating contrarian, often unorthodox, ideologies. Today, the population of many developed countries across the world has lost confidence that political leaders or fiscal policymakers (central banks) can or will deliver on their promises. This lack of faith and trust creates fear and uncertainty.
Our investment process is designed to ride the long-term “tides” of fundamental valuation, navigate the medium-term “waves” of macro themes and geopolitics, and largely ignore the short-term “ripples” that emanate from daily news headlines or TV’s talking heads. And populism is likely a very large wave that’s headed directly at the markets. To assess and navigate the potential impact of populism on investment opportunities and risks, we use two of the frameworks in the Why? step of our investment process: macro-thematic analysis and geopolitical analysis.
Populism doesn’t change our determination of long-term fundamental value but it does impair the risk-adjusted compensation over a shorter investment horizon.
As a macro theme, populism doesn’t manifest itself in exactly the same way everywhere. In fact, it doesn’t even manifest itself everywhere. But populism has emerged in several parts of the world, and it has done so in different ways—sometimes on the left of politics, sometimes on the right, sometimes on both.
- In the U.S. presidential primary race, you have strong populist components on both the right (Trump) and left (Sanders).
- Greece has been run by the far-left Syriza government for more than a year.
- In Spain, the rise of populist parties in the December 2015 elections has resulted in the lack of a formal government, as no one party gained an absolute majority and no two parties are willing to form a coalition with one another. A new election will take place in June.
- In the United Kingdom, a referendum on maintaining European Union membership will be voted upon in June.
From a macro-thematic perspective, populist movements share common features. First, they arrive from voter dispassion towards established political leadership. Second, they exhibit, in one form or another, a voter preference for a policy shift—a regulatory shift—that is either away from free trade or away from free migration of labor, or both.
Bottom line: A higher probability of such policy shifts is a negative. We therefore choose to reflect the macro-thematic elements of populism as a haircut to near-term, risk-adjusted compensation of assets in affected places. Populism doesn’t change our determination of long-term fundamental value but it does impair the risk-adjusted compensation over a shorter investment horizon.
Populism points towards increased risk and uncertainty in our geopolitical analysis as well. That’s because leaders of populist or populism-inspired movements, such as the “Vote Leave” campaign in the U.K., have every incentive to go up against the political establishment. The establishment, in turn, has an equal incentive to face down the populist or populism-inspired insurgence. We therefore have a situation where the players—in a game theoretical sense—have a mutual incentive to raise the noise level to deliberately increase the stakes and inject geopolitical risks into market and currency prices.
That is what we believe is likely to happen in the U.K. as the referendum campaigns get going, which have about two months yet to run. In addition to these diametrically opposed objectives, the other important consideration within our game theory framework is the relative powers of the players. Which player is the most powerful and which one is the most likely to prevail?
Well, in game theater situations like the Brexit referendum, a simple proxy for the relative powers of the players is the expected relative vote share for each side. Opinion polls are currently very close between staying in the EU and leaving the EU. Most of the polls show a very small bias towards staying, but a select few show a bias towards leaving, with the average gap being very narrow. This indicates roughly equal bargaining powers in a game theater sense—equal powers and opposed objectives.
We have seen this scenario before with various ramifications. It is just about the simplest game theater set up you can have, where the investment implication is simply heightened risk. So, what we’re observing with populism, and in particular with the U.K., is reduced compensation and raised risk.
Investment implication: That is why we have reduced our long U.K. equity exposure even though equity is fundamentally attractive in the U.K. And that is also why we increased our short exposure to the fundamentally unattractive British pound, which we have implemented by adding a put option that also benefits from increased volatility.