While in the short-term the equity markets are falling, we are told again and again that if only we look just beyond the horizon, all will be unicorns and rainbows. The 'buy-and-hold'/invest-for-the-long-term mantra is what pays most of Wall Street's bills and keeps your wealth manager in his Hawaii vacation home. However, while the current jitteriness is ascribed (potentially wrongly as we noted yesterday [4]) to the 'fiscal cliff', as Morgan Stanley notes, "A near-term fiscal cliff resolution won’t remove politics from the investing calculus, far from it. Developed-economy governments have significant negative net worth, which means that the public sector will ultimately impose a cost on the private sector. The political process will determine when and how the private sector bears the cost. This political uncertainty seems likely to remain a persistent and potentially critical factor for investors over the medium term. At a minimum, it will likely affect, detrimentally, the valuation of risky assets." Must read.
Via Morgan Stanley: The Very Political Economy,
Politics has become a more intrusive factor for investors. The prospect of heightened political uncertainty is one reason to think risk asset valuations will be structurally lower compared to the past 30 years.
Politics can always affect investors. However, political risk has generally been a second-order issue for investors in developed markets. More to the point, the major political trends in the two decades after 1980 were supportive for risk assets generally and equities specifically. There was a broad shift to lower taxes, reduced regulation – notably reduced finance-sector regulation – increased openness to trade, and less protection for labor. All this contributed to higher earnings and higher valuations for risk assets.
Several things have now changed. First, governments are broke. Exhibit 1 shows an estimate of governments’ net worth, as a percentage of current GDP. This is essentially a comparison of the discounted value of their income versus liabilities. There is no point quibbling about methodology: under any plausible methodology most western governments have negative net worth.
[5]
The significant negative net worth of government means there is no question that the public sector will have to impose a cost on the private sector. The only questions are when and how. The political process will have to answer those questions. Investors may hope the inevitable cost will be imposed in a way that minimizes economic or financial pain, but history suggests that politicians aim to minimize political pain.
The second change is the rise in income inequality. Rising inequality was very likely caused, at least in part, by some of the factors that supported equities: increased free trade, lower direct tax rates and labour market deregulation. The bull markets also increased inequality. If the richest households started with twice the average value of financial assets in 1980, then 20 years of 10% asset price growth would, all else equal, increase that ratio to 13 times by 2000.
[6]
It was acknowledged at the time that many of the reforms introduced after 1980 would initially provide disproportionate benefit to high incomes – but, in theory, benefits would trickle down. Exhibit 2 shows real income in the US, by income quintiles (20% buckets). The bottom three quintiles – the bottom 60% – have seen almost no income growth since 1980. (To be precise, real annual income growth in the bottom three quintiles has averaged 0.1%, 0.2% and 0.3%, respectively, since 1980.) Whatever trickled down, it wasn’t income.
[7]
It seems plausible that any attempt to reduce inequality could see backsliding on trends that assisted risk assets over the past 30 years. One example is the trend to lower effective tax rates on corporate income (Exhibit 3).
[8]
Rising inequality has gone hand-in-hand with rising political polarization. Exhibit 4 shows income inequality in the US (Gini coefficient) and a measure of polarization in the US Congress.
Ominously, but unsurprisingly, public austerity typically triggers social and political stress. Exhibit 5 shows the incidence of various political disturbances in Europe over the 80 years to 2009. The vertical scale is the number of incidents per year, per country; the progressively darker bars correspond to periods of greater austerity. The events are riots, demonstrations, general strikes and assassinations (the CHAOS bar sums the components).
[9]
It’s a cliché, but it’s true: investors hate uncertainty. The rise and rise in an index of policy uncertainty in Europe and the US has gone hand-in-hand with falling risk free rates (Exhibit 6).
[10]
The forward-looking point is that political uncertainty seems likely to remain a persistent and potentially critical factor for investors over the medium term. Structurally higher political risk reflects the structural economic problems that are likely to dominate the economic outlook for some time. This will very likely affect, detrimentally, the valuation of risky assets.