Politics trumps economics in a new age of volatility

Faced with turmoil and investor confusion, soft, social issues are suddenly becoming important to the developed world and institutions are realising it's no longer enough to rely on quantitative measures alone.


Why are investors engaged in a 'dash for cash' (or a flight into any havens that they can find)? It is not hard to think of reasons: doubts are rising about the future of the eurozone, the underlying developed world economic data are grim - and in the US there is concern about the prospect of a 'fiscal cliff', or new debt debacle.

But in addition to these obvious concerns there is another, more subtle factor at work. As turmoil builds, investors and policy makers are being tipped into cognitive shock. In the past few decades, most investors have operated as if the world was a place in which the key variables could be plugged into a spreadsheet or computer model. Ever since the computing revolution took hold on Wall Street and the City of London in the 1970s, finance has been treated not as an art but a science - and banks have operated as if computer models could not just explain the past but predict the future, too.

Now those 'quants' and rocket scientists find themselves at sea. Computer models alone can no longer calculate meaningful probabilities about what will happen next in the eurozone. Instead, what really matters now in places ranging from Finland to Greece are non-quantitative issues such as political values, social cohesion and civic identity. Above all, the question of "credit” is key to working out whether bonds can ever be repaid. But this is not credit in the mathematical sense by which banks have often defined it (as a projected probability on a chart), but in the old fashioned, Latin - social - meaning (trust). The crucial variable, in other words, is whether voters have faith in their governments and central banks. Do they trust the safety of their banks? Are citizens willing to trust each other, and co-operate, when pain is imposed?

To be sure, these non-quantitative issues would be familiar territory to any banker who practised the craft in the middle of the last century. Seven long decades ago, when trainees joined institutions such as JPMorgan and Citibank, for example, they were taught that they could not assess credit risk from quantitative factors, such as cash flow, alone. Questions of "character” mattered, too, be that of companies, individuals or countries. When investors analysed risk in emerging markets such as Argentina, Turkey or Indonesia, they paid close attention to political risk, civic values and social culture

But in supposedly 'developed' countries, such as the US and Europe, these 'soft' issues have often been ignored. Instead investors have focused, almost exclusively, on numbers such as inflation and debt. Severe political risk was seen as an emerging markets problem; it applied to banana republics, but not the western world.

As a result, the turmoil in the eurozone leaves many investors dazed and confused. Never mind the fact that the fiscal 'numbers' of many emerging market countries now surpass those of western nations, or that some emerging market nations are now considered less risky than developed ones. (Mexico, to cite just one example, has more credibility in the credit derivatives market than Spain.) The really big shock is that soft, social issues are suddenly becoming crucial to the developed world. Most notably, with voters in Europe having kicked out almost a dozen incumbent governments, and political extremism on the rise, questions of social cohesion and trust matter deeply. This type of risk cannot be factored into a spreadsheet.

The good news is that many institutions are scrambling to embrace this mental shift. Most large investment banks on Wall Street and in the City have expanded their political and social expertise this year. Rating agencies such as Standard & Poor’s have been subtly changing their internal ratings processes to emphasise soft factors, such as political culture. Large asset managers are telling their clients that it is foolish to rely on models alone, and some government institutions are adapting, too. Senior officials at the European Central Bank have started memorising briefing packs about eurozone social and political trends, alongside their usual monetary numbers. "It’s quite a change,” one senior ECB official told American investors last month. "I spent most of my career studying economics. Now I study political parties, too.”

But the bad news is that the new mental landscape is terrifying for many investors (or policy makers), particularly those who have spent their careers relying on computer models. What makes this landscape doubly unnerving is the sheer complexity of all its moving parts. Or, as one of America’s biggest asset managers explains: "We like to deal with probabilities, but there are just too many possible outcomes to the eurozone to work them out.”

Little wonder, then, that so many investors have been sitting, frozen, on the sidelines, refusing to invest their money or simply dashing for havens. The problem is not simply that the outlook for the eurozone looks dark, but that these shades of black defy any system for modelling risk. There is little chance of this changing soon. We have entered a new "age of volatility”, and not just in finance and economics, but in politics and society, too.

Copyright The Financial Times Limited 2012.

InvestSMART FORUM: Come and meet the team

We're loading up the van and going on tour from April to June, with events on the NSW central & north coast, the QLD mid-north coast and in Perth, Adelaide, Melbourne, Sydney and Canberra. Come and meet the team and take home simple strategies that you can use to build an investment portfolio to weather any storm. Book your spot here.

Want access to our latest research and new buy ideas?

Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.

Sign up for free

Related Articles