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Sometimes, the best answer is “I don’t know”

Emma Alberici: Tell us, how much longer do you expect the shutdown to continue and how do you expect it to end?

William Kristol: Well, if I knew the answer to that, I'd probably be, I don't know, making bets at Las Vegas, not chatting with you here on Lateline.

ABC Lateline interview with William Kristol, Editor, Weekly Standard, 7 October 2013 

The arguments about the US Government shutdown and debt ceiling have been kicked down the road until the first quarter of 2014, but they have not gone away.

Investors left confused by 'experts'

Let’s examine some of the simple analysis, excessive reliance on history and complacency that has accompanied the discussion of these events by some of the financial media and investment industry. Much of this has just confused investors grappling with how to deal with a complex situation.

Perhaps this is one of those times when William Kristol’s “I don’t know” should be a more common response. Instead, many have been too eager to provide specific views and investment strategies designed to play the expected outcomes.

For example, as the US headed to its 1 October 2013 Government shutdown and the ensuing debt ceiling debate, a strategist at a major Australian bank was quoted in The Australian Financial Review on 30 September 2013 saying, “If there is a legitimate concern about the US Government defaulting on a payment then that is a serious issue and a US dollar positive.” The mind boggles. So we should all buy the currency of the very country whose Government was about to lay off 800,000 workers, slowing economic growth, and the same country that is threatening to default technically on official debt payments due within a month. In fact, the US dollar was generally weaker against major currencies until debt negotiations began on 10 October.

Part of this is the Pavlovian response of markets to previous ‘risk off’ periods where the US dollar and bonds tend to rally as supposed ‘safe havens’. However, it makes sense to adjust this analysis to reflect the fact that this time it is the US Government that is the cause of the actual ‘risk’ events that investors may be seeking shelter from.

This over-reliance on history can also be seen in the commentary casually dismissing any negative investment implications from the shutdown and instead seeing it as a buying opportunity primarily because the market went up, on average, in the weeks or months after the previous 17 shutdowns. The fact that the last of these was 17 years ago, the sample size is small and these shutdowns occurred in vastly different economic and investment environments seems to be largely ignored. History can provide useful information but should hardly be used as a definitive guide to the future.

This view was taken further in The Australian on 8 October 2013, “Relaxed investors spot a silver lining”, where we were told that many money managers see the shutdown and debt ceiling situation as a “blessing”: “Any stock sell-off would be a great buying opportunity” they are saying.

Daily noise has little long term relevance

This view seems casually to dismiss two points.

First is the low probability, but still present, risk that the endgame could be a much more adverse outcome than in the past, including a default or US credit downgrade, in which case any stock sell-off would likely be followed by a much bigger sell-off.

Second, even if sensible resolutions happen, taking advantage of prior weakness that has typically only been a few percentage points is hardly a great buying opportunity and will ultimately be largely irrelevant to longer term returns. The much more important drivers of such returns include elements such as current market valuations, the course of corporate earnings and monetary conditions, not the historical short term response to previous government shutdowns or debt ceiling debates.

One reason subsequent ‘short term’ returns were on average better after previous government shutdowns is that markets typically fell through the shutdown period so part of the better than average return was simply mean reversion, especially since these events have so far turned out to have little overall negative economic impact. Further, most of them occurred in the 1980s and 1990s, part of America’s largest ever equity bull market.

Further, the fact that markets have taken a relatively benign view of the shutdown and debt ceiling may increase the chance that it turns out worse than expected. In the absence of a market panic, politicians may feel they can drag the situation on with minimal adverse consequences. Only a true crisis in markets, the argument goes, will be enough to push politicians to act and get a responsible deal done. To the extent this is true, reliance on historical events may actually increase the chance that this time is different. These types of feedback loops make analysis of these situations very complex.

What does this mean to investors?

First, investors need to be sceptical about history and realise that politicians can knowingly or unknowingly lead the world to some pretty disastrous outcomes. Even the low probability, but potentially disastrous, outcomes such as an actual debt default cannot be completely ruled out just because they are so rare. Of course, this is a challenge for investors as it doesn’t make sense to make dramatic adjustments to a portfolio to reflect such a low probability scenario.

Second, context matters. In 1980 the debt ceiling was under $US1 trillion. Even as late as 1996 it was under $US5 trillion. Today it is $US16.7 trillion. Future debt ceiling debates are likely to become more difficult and dangerous as debt heads towards 100% of GDP. Indeed, the current situation may focus greater ongoing attention on the long term unsustainability of the US fiscal situation despite the consensus view that any real danger still seems some years away. This could have a real and enduring impact on markets beyond the current deal, especially since it is a short term deal only.

Third, if US stocks represent good buying today it cannot simply be because they have fallen a few per cent recently in reaction to news about the shutdown or debt ceiling. Sure, strong short term rallies should be expected when deals are done. But attractive long term stockmarket returns rely on more than just a short term bounce on the reversal of bad news. Such returns will come because, amongst other elements, stocks are currently trading at reasonable or cheap valuation levels, because of good earnings in the future and because of a favourable future monetary background. Currently, there are question marks on all of these.

Markets are not attractive or unattractive from a long term perspective based on how they are reacting to the major news events of the day. While these may be important for day to day swings – and such swings may be large - they rarely are the big driver to long term returns unless, of course, the worst case low probability outcomes occur. Focusing only on debt and shutdown as a selling or buying catalyst may miss changes in other important longer term drivers to returns.

Finally, when it comes to US politicians, don’t expect them to be rational or always go down a predictable path. The words of Winston Churchill are relevant, “We can always count on the Americans to do the right thing, after they have exhausted all the other possibilities.”

Dominic McCormick is Chief Investment Officer and Executive Director at Select Asset Management. 


 

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