Alex Scott, Deputy Chief Investment Officer.
10 February 2017.
What a difference a year makes! A year ago, investors were in panic mode, still battered by the shock of the Chinese devaluation in August and seeing new terrors around every corner. Equities were under strain and riskier credit markets like high yield bonds were under acute pressure, with spreads pricing in extreme levels of default. Commentators put forward dozens of reasons for the market weakness – from an impending Chinese economic collapse, to the decimation of the oil industry and defaults by oil-producing nations, to the end of the US business cycle and an imminent recession, with all the implications this would have globally.
Our analysis suggested this was way off the mark – that we’d see higher defaults among riskier borrowers in the energy sector, but little wider impact. So no end yet to China’s growth or the US upswing, and that we should therefore persist with riskier equity and credit investments in the face of market panic. By and large, that paid off. But the experience is a very sound reminder of psychology and perception in markets: that consensus fears can be misplaced, that what seems obvious doesn’t always come to pass, that (as we were reminded on more than one occasion in the political history of 2016) what seems impossible can spring a surprise, that patterns of events don’t always repeat as we expect, and that the market pricing of risk is not always as efficient as we would like to believe.
“What seems obvious doesn’t always come to pass, that what seems impossible can spring a surprise.”
Today, the consensus is more relaxed about economic risk. If anything, fears centre on the risk of an overheating now, not the undershoot that investors worried about a year ago. Investors’ fears are centred on political risk; unsurprisingly, given the seismic political shocks of Brexit and Trump. They now fear the possibility of a repeat experience in France, and a victory for Madame Le Pen. There’s deep scepticism about the opinion polls, which show that Le Pen would be easily beaten by either Macron or Fillon in the second round run-off of the French election; after all, the polls got Brexit wrong and they got Trump wrong, didn’t they? Well, up to a point, but as ever it is important to look critically at received wisdom and question consensus.
EU referendum polls running up to the referendum were extremely close, with some showing a Leave lead; perhaps it was the interpretation of these polls that was wrong, with analysts and commentators expecting a ‘typical’ late break back to the status quo inside the polling booth.
In the US, most nationwide polls showed a small lead for Clinton – there were relatively few state-level polls, and these were sometimes of lower quality. As it turned out, Clinton did indeed win with a small lead in the nationwide vote – so perhaps it was the interpretation of nationwide polling in the context of the US’s complex state-by-state electoral college that failed, rather than necessarily the polls themselves, and even there it was a close run thing. If as few as 50,000 votes across four key states had gone Blue rather than Red, we would today be talking about President Clinton’s narrow win.
So while we should approach polls showing the weak position of Le Pen in a hypothetical second round run-off with appropriate caution, let’s not make the mistake of extrapolating the perceived failures of polling in the UK and US elections to every subsequent poll.
Markets don’t know how to price the risk of a Le Pen win, or its implications if she does indeed gain the power to take France out of the Eurozone, but they are clearly attempting to do so: French government bonds have traded out to their widest premium versus German Bunds since 2012 and the tail end of the Eurozone crisis. The Euro is now trading within a couple of percent of a 15 year low versus the US Dollar, far lower than its levels even at the height of the Euro crisis.
Yet, if the worst political risks don’t materialise in Europe this year, we see an economy performing above trend, with modestly rising inflation: scope perhaps for the European Central Bank to cut back a little further on its quantitative easing programme and provide a boost to the Euro.
To be clear, we do not hold French government bonds in the Balanced portfolios, and we have hedged all of our Euro exposure effectively. Both assets would likely come under some pressure if Le Pen wins the presidential election – but the extreme pricing on show and the existence of a widely-held consensus view that politics, and Eurozone politics in particular, is a key risk for 2017 suggests that an opportunity may materialise in the weeks ahead. The consensus can be right – but we must keep questioning and remain mindful of the times where it can be very wrong indeed.
