As I put down the newspaper this morning that warned me that running without enough salt may kill me, I was confronted by the breaking news about the horrific bombings in Brussels. A salutary reminder that risks are all around us and life is fragile.
Asset markets also struggle to deal with shifting risks. This time last year investors were worried about the tenuous state of the Greek economy and the effect of falling oil prices on emerging markets.
Indeed, eight years ago the very existence of the capitalist system was brought into question as the whole banking system starting grinding to a halt in the Credit Crisis. However, this heralded a new era of risk that we are living with today.
Prior to the Crisis, the markets worried about the economy. Yes, exogenous risks existed, such as the tragic events of 9/11, but otherwise markets were steered by the economy and profits.
On a day-to-day basis during this time investors were peeled to their computer screens every 2pm on a Friday when the US trade deficit figures were announced or Thursday at 11am when the inflation data was published.
The Credit Crisis changed all this.
The need for central banks to take extreme monetary action, largely by pumping very large sums of money into the economy using quantitative easing, with the sanction of governments, suddenly meant that what the Finance Minister or Central Bank Governor says next matters more than last month’s trade figures. Yes, the economic data is still important but now there is a new layer of risk to contend with.
Political risk and policy risk are very difficult for the markets to judge. The markets struggle to discount a surprise budget, the emergence of a populist politician or binary events such an interest rate decision or Brexit vote. Politicians are not like homo economicus, they do not act always for profit maximisation, and can move in mysterious ways.
Worse, the effects can be widespread. A local wayward decision here or policy mis-step there may be forgiven by the markets. However, the global connectivity of markets can mean that contagion from one of these political banana skins could have wide-sweeping implications. If Mr Trump gets into the White House and builds his wall along the Mexican border and starts instructing companies to on-shore production, the US stock market is not going to react in isolation.
The state of the global economy is OK but not glowing with health. The slowing of demand growth in recent quarters along with the persistent heavy weight of debt means that there is extra sensitivity to any changes that may tilt growth either way. This knife-edge tension has been exacerbated by the rise of the political risk and something that all investors are having to contend with.
At Equilibrium we are having to deal with these risks like all investors. We do adjust positions corresponding to changing risks but we are careful not to let the tail wag the dog. This means we will not try and second-guess the outcomes and place investment bets on this basis.
Take the Brexit vote, for instance.
We are well aware that sterling will fall in the event that an ‘exit’ vote prevails. In this circumstance, the stock market is likely in the short-term to favour large stocks that have greater overseas earnings. However, our UK equity portfolios have greater concentrations in mid- and small sized companies. If we thought an ‘exit’ vote had a chance, should we not start shifting the portfolios to larger companies?
We do not believe this would be the right approach. For a start, not all large companies will benefit – many hedge their currency exposures, for example. More importantly, however, we invest in the small and mid-sized companies because of their ability to grow even when economic growth is sluggish.
The chart below shows the relative performance of the FTSE 250 Index, in purple, (where EQ has greater holdings) against the FTSE 100 Index, the orange line, over the last 30 years:-
Source: Reuters Datastream
As you can see, the smaller companies have done better than their larger peers over many different economic cycles.
Whilst we acknowledge there may be a short-term reversal in this performance if the vote is to ‘exit’, we believe our clients are better served with this smaller company exposure over the medium to long term. By shifting the holdings to larger companies now would mean, a) we think that the UK may vote to leave the EU (we don’t), and b), we are willing to bet our client’s money on this hunch.
We look to invest our client’s money, not punt with it and so whilst accounting for the rise of political risk, we will not let it dictate our core investment principles.