The market reaction to excessive political turmoil has been extraordinary over the last year. Any investor with a crystal ball would have shunned risk assets, given the traditional relationship between political uncertainty and equity market volatility. But they would have been wrong. Incredibly, markets dismissed each event with increasing disdain.
There is no sign of a let-up in political uncertainty, with a full calendar of events to contend with. This includes the French, German and Dutch elections as well as milestones along the road to Brexit. As if that wasn’t enough, a Nato-sceptic US administration could embolden Russia on Europe’s eastern border and elsewhere.
For now, the US is gaining the most attention. In just his first 10 days in office, President Trump made two proclamations, signed ten presidential memorandums and rubber stamped seven executive orders. Most notably, new immigration curbs have caused outrage in some circles, including technology executives worried about free movement of the skilled labour so necessary for innovation. Investors have been left wondering what to make of it all and are trying to focus on a promised tax and infrastructure plan that has been slipping down the legislative agenda. Political risk in the US is likely to remain elevated.
So, the key question is: will 2017 be another year of the “new indifference”? Or will we see a return to the “old norm”?
Investors must first consider why markets chose to ignore political risk last year. People have joked that markets cared about the Chinese slowdown for a matter of weeks, Brexit for a matter of days, Trump for a matter of hours and the Italian No vote for just minutes. But markets don’t just suddenly get tired of political risk; there are profound reasons why it stopped figuring so highly.
The global economy started recovering at the start of 2016, and leading indicators of manufacturing gathered steam. The US corporate earnings recession was starting to ease, helped by an improving supply/demand profile in commodities. There were also no liquidity crises, meaning that capital continued to flow freely as the surprises kept coming. Finally, there was a more secular driver behind the markets’ apparent ease with the events of 2016 – the profoundly altered nature of equity ownership.
Many commentators have spoken of the rise in equities from 2009 onwards as being a hated rally, because of low retail investor participation. In March 1999, the New York Stock Exchange celebrated a major stock market milestone by ordering thousands of hats with “Dow 10,000” emblazoned on them. As the Dow hit 20,000 last month there was much less fanfare.
Hatmakers won’t be the only losers this time. The global equity market rally since 2009 has been remarkably bereft of retail participation thanks to the twin “turnoffs” of the technology, media and telecoms unwind and the 2008 crash.
This is important because asset flows from institutions and wealthy investors tend to be “stickier” than those of mass-market retail investors. While it can’t be said that all capital markets have grown indifferent, equities appear to have discovered a new structural robustness towards political risk that should inform asset allocation decisions, and ultimately investment performance. But this is no free lunch; equity market progress will only persist as long as economic and earnings growth can keep recovering unhindered.
Even wealthy, longer-term investors who can afford capital impairments would balk at holding equities in the face of deteriorating fundamentals. The risk here is that the Trump administration interferes to such an extent that the efficient allocation of capital in the US economy gets completely distorted, with grave implications for growth. But this seems unlikely, given competing presidential priorities and a Republican Congress that is less than sympathetic to the idea of an all-out trade war.
Of course, valuations still count and, with the market looking expensive on price-to-earnings multiples, longer-term investors hoping for double-digit returns in 2017 may be disappointed. After all, even improving growth and earnings can’t support upward re-ratings in equities exponentially.
For investors looking for a reasonably steady return profile, this suggests a diversified investment portfolio with a meaningful equity allocation but also significant exposure to more independent sources of return. These include selected non-government bond sectors which can offer reliable and repeatable income characteristics.
The “New Indifference” to political risk may continue to present buying opportunities for the tactically minded, in the event that some market participants break rank, panic and sell on negative headlines. Timing is of course notoriously hard but investors should console themselves that an equity market focused less on noise and more on fundamentals can only be a good thing.