Thursday, June 14th, 2018
As bottom-up, fundamental investors, we tend to focus on the things that affect a company’s business model and earnings. Our philosophy necessitates that over a sufficient time frame, these factors will overwhelmingly drive stock returns. It is no secret however that in the short-term, markets are prone to bouts of oscillating fear and greed which are often driven by factors with no tangible ties to future fundamentals. Markets hate uncertainty almost more than anything else. It invariably leads to volatility, fear and short-termism as investors grapple with pricing in indeterminate risks.
It is in this context we find global markets seemingly more prone to political risk than at any point in the last five years. Donald Trump’s residency in the White House over the last 18 months has been a significant factor. It has marked the resurgence of American protectionism and anti-globalism, with major international agreements being renegotiated or exited seemingly at a whim. Traditional allies have been scorned, forcing many to strengthen non-US ties and disrupting the international order. Bellicose exchanges with China and North Korea have also raised global geopolitical tensions and an ongoing investigation into Russian interference in the US election has dominated headlines.
Figure 1. Ongoing negotiations between Trump, Kim and Xi
Source: Financial Times
In Europe, the final week of the longest political stalemate in Italian post-war history culminated in the election of a populist coalition led by Prime Minister Giuseppe Conte, a law professor with no formal political experience. With the parties’ histories of antagonism towards the EU, the term ‘Quitaly’ has entered the political and economic psyches, with questions over the EU’s sustainability once again emerging. This of course echoed the sentiments espoused by the British people during the Brexit vote, which in itself continues to be a source of instability. The multi-year secession plan will likely be executed by several cabinets and possibly opposing parties with the ultimate product uncertain both in terms of timing and outcome.
Figure 2. Cracks showing in the EU-Italy relationship
While Italy has struggled to form a cohesive government, China has had no such problem. President Xi Jinping has become the most powerful leader in China since Mao Zedong, recentralising the government around the Communist Party and himself personally. Dictatorships are typically destabilising forces for economies, but we have never seen one with the scale or sophistication of modern-day China. Investors the world over have been left to ponder whether China’s unwillingness to democratise its government will disrupt its inclination or ability to open its economy and markets. Moreover, with such a high degree of certainty over future leadership, China has been afforded a rare ability to think strategically over the course of decades, not years. Contrasted against Trump’s obvious desire for short-term political victories in the face of extreme division and partisanship in the US, and it creates a very interesting dynamic between the world’s two preeminent powers.
On our own shores, politics has long descended into pettiness and mediocrity as we face the prospect of a fifth prime minister in as many years. The somehow already apparent failure of large national projects such as the NBN and the highly politicised energy market have disrupted major industries and must be seen as a tangible consequence of political volatility.
The key, particularly as Australian investors, is to separate the bark from the bite or so to speak. Which of the above risks may pose tangible threats to the future earnings of Australian companies and which are more likely to be absorbed in the endless churn of global markets? The introduction of US tariffs sparking a Sino-American trade war might affect global supply and demand for bulk commodities on the one hand, but many industries will be generally unaffected. Even then, Australia’s exemption from such tariffs has in this case ensured even those companies will be relatively unscathed.
Figure 3. ASX 200 price chart, annotated to show political event risks
Source: Thomson Reuters, AFR, Clime research
Likewise, the escalating tensions between the US and North Korea are concerning, but the two countries have officially been at war for nearly 70 years and the possibility of military conflict remains remote. Likewise, Italy’s populist renaissance may create problems for the EU, but any decision to leave the union would be extremely complex, expensive and protracted, making its likelihood very low at this point in time. However, because these situations are volatile, and involve inexperienced, unproven or irrational leaders, they are by their very nature unpredictable. Markets do not like uncertainty. It is especially difficult to price political risk and so volatility on this plane has tended to lead to overreactions from investors.
With greater doubt, comes greater risk aversion which, among other things, tends to shorten the focus of investors to months rather than years. Investors are unwilling to take long-term bets when they cannot predict what the world will look like in three or five years. Of course, this is a fair approach in the context of multi-billion and trillion-dollar capital allocation decisions but for nimble, fundamental investors, it can be exploited with discipline, valuation focus and conviction. Secular growth driven by sustainable reinvestment, paired with a supportive balance sheet and a strong management team to drive it all, are hallmarks of good investments. The political machinations of far flung leaders throughout the world will do little to disrupt such companies over a fuller investment horizon.
From an Australian perspective, a relative lack of dynamism among the country’s largest companies means these opportunities are often on the smaller end of the market. We do not house the world’s preeminent disrupters – Amazon, Netflix, Baidu and others. Our largest companies are banks, embroiled in a royal commission, and major miners, which may be caught up in Sino-American disputes or rapidly evolving Chinese environmental policy. Dig a little deeper and you will find dozens of companies devoid of such concerns and poised to grow independently of politics and policies. It is these opportunities where capital can be deployed shrewdly to exploit any short-term volatility in markets driven by political uncertainty.