Political uncertainties weighing on the markets

One answer to cope with political uncertainty: diversification

Comparing investors to tightrope walkers is obvious: both are constantly striving to perform a tricky balancing-act. When making decisions, investors are seeking to find the ideal balance between generating a good return and shouldering risk against a backdrop of uncertainties.The two crises involving Greece and China remind us – as if we needed to be – that investors are always operating in a world full of risks.

We have pinpointed three prime sources of risk for financial markets – economic, financial and political. The continuing crises in Greece and China involve a cocktail of political and economic factors: political in the sense that resolving these crises will hinge on decisions made by governments, even if the root causes lie in economics. In the case of Greece, which accounts for less than 2% of eurozone GDP, ‘Grexit’, if it were to happen, ought to have only a limited impact on the eurozone’s economic growth outlook. As the country’s public debt totals EUR320bn, solving the financing issues is well within the means available to the Troika.

Conversely, the decision to make new funds available to Greece will rely on a common political will, bringing together the Greek government on one side and Europeans on the other. All the vacillation over the past five months has demonstrated that decisions have been much harder to make than the real weight of the economic and financial stakes might have suggested.

Resolution of the Greek crisis, which looks imminent at the time of writing, would only partly solve the eurozone crisis, which has far deeper structural root causes bound up with the dynamics of many national economies in Europe.The Great Divergence between the stubbornly upward trajectory being taken by public debt and the downward trend on economic growth reveals that the key question is knowing not whether governments will default on their debt, but when.

Most eurozone countries, with public debt/GDP ratios averaging close to 100%, are tracking unsustainable debt paths over the long run. Greece’s case cannot be regarded as a laboratory experiment from which lessons can be distilled and applied on a much wider scale over the next few years. Final resolution of the Great Divergence calls for structural decisions to be made, most notably to complete the unfinished business of the eurozone project (see the ‘Topic of the Month’ article on page 12 for more details). The eurozone’s fate reduces to one of two alternatives: fiscal union or dismantling of the union into some form or another. Fiscal union will rely on some very uncertain political decisions. At this stage, we can safely say fiscal union is far closer to a utopia than a reality.

For a number of years, political uncertainties have regularly resurfaced to spook the markets.These tend to have two significant implications. First, uncertainty is far harder to grasp than risk itself. Uncertainty is not quantifiable as it arises from decisions being made by a handful of individuals.There are no predetermined models or analytical frameworks to help measure political uncertainty and convert it into a neatly quantified risk premium to be factored into asset pricing. Second, uncertainty, like risk, calls for portfolios to be diversified.The purpose of diversification is to protect portfolios against unforeseen shocks caused by political uncertainty that triggers some sort of financial or economic crisis.To protect portfolios, investors need to look closely at assets whose market behaviour, in times of crisis, might provide such a shield. US Treasuries and German Bunds, cash and, to a lesser extent, illiquid assets, like private equity or hedge funds, could fulfil this role.