VIOLENCE in Israel and Gaza may seem to be a solely political (or geopolitical) issue. But politics has implications for all investments, and particularly sovereign debt. Governments drive policy and policy drives the bond markets.
Instability used to be more of an issue for emerging markets. But we are now entering a new age of political risk. Rising tensions between nations (and within them) signal a struggle ahead for governments, and a rocky road for investors.
Consider the evidence. Firstly, the political direction of many countries is in a state of flux. We’ve just seen elections in the US and leadership change in China. Australia, Japan, Italy and Germany are holding contests over the next 12 months. While the electoral landscape is always important, there are now heightened ramifications.
Conditions in the developed world are unlike anything seen for two – perhaps three – generations. High unemployment and slow economic growth are breeding discontent, and political extremism can thrive in such circumstances. The outcome of each of these upcoming elections is a potential force for instability.
Secondly, tensions both between and within nations are rising across the world. In Europe, structural flaws and competing national interests are leading to strains between countries. At the same time, politicians are engaging in interventionism in the corporate and financial worlds. And the US faces its own looming problems. The fiscal cliff is approaching fast, and the country is reaching the critical day when its spending on debt servicing will outstrip investment in defence. History suggests that, at times like this, isolation or violent expansion tends to follow closely.
Thirdly, sovereign debt levels in the Eurozone are driving social tensions. The situation has become untenable, and there appears to be no solution in sight. Spain is a prime example of the powder keg the Eurozone is fast becoming. If you were worried about Greek debt, you should be doubly worried about Spain today. If its politicians don’t implement reform, downgrades are inevitable, and its economy’s struggle will intensify. Yet if the Spanish government does institute deeper austerity, greater social unrest could be inevitable. High youth unemployment – currently 54 per cent in Spain – is one of the two typical ingredients for civil war (the other being bad harvests). While I am not suggesting war will break out, it does highlight the near impossible situation facing Spain’s politicians.
Fourth comes the specific risk of default. This threat, springing from the political situation in many G12 economies, is now very real. In recent years, virtually all the countries our fund monitors have been downgraded, with notable exceptions including Canada, Sweden and Australia.
And these exceptional economies are fairly unusual. Their banks were more robust going into the 2008 crisis, and thus required less support. This solidified their fiscal positions, offering relatively lower default risk than others. These combine to leave them with a more stable political situation. Their circumstances are unfortunately rare.
Ultimately, even countries like the US and the UK give us reason for concern. Although US treasuries and UK gilts have been bolstered as safe haven investments, emergency monetary measures taken by central banks – in the form of quantitative easing – are fanning inflation fears.
Faced with this new era of political risk, what should investors do? Factoring in political risks has always been a fundamental part of the investment process. But we are now in largely unchartered waters with potential instability unlikely to disappear.
And the situation could get worse, with Middle East tensions again pushing up the price of oil, and escalating regulatory pressures potentially encumbering the liquidity of bond markets.
Financial markets are no longer driven by economics alone and market participants can no longer rely on traditional investment theory and doctrine to make a profit. In this era, we must try to adapt accordingly.
Neil Williams is chief economist for global government and inflation bonds at Hermes Fund Managers.