Winds of change

PORTFOLIO POINT: Changes in the unelected regimes of China, the Arab states and global central banks should prompt investors to reassess their hedging strategies.

You could be forgiven for thinking a watershed event was in store with parliamentary speaker Peter Slipper stepping down amid allegations of sexual harassment and the misuse of travel vouchers. With the likely loss of a seat in the House of Representatives, the Gillard government’s majority now effectively rests on the continued survival of Craig Thomson, another politician facing possible charges of impropriety. And should independent members such as Andrew Wilkie decide to vote with the opposition, that parliamentary majority could fall much sooner than that (for what this could mean for policy, see Life after Gillard).

Yet as the French – who almost invented the art of political scandal – say, plus ça change, plus c’est la même chose. The more things change, the more they stay the same.

France is also facing a political reckoning with the likely election next month of socialist candidate François Hollande, the so-called 'Monsieur Normale’ who replaced disgraced flâneur Dominique Strauss-Kahn as his party’s candidate. But unlike Australia, there are real ideological differences between France’s party of the left and the Gaullist government of incumbent Nicolas Sarkozy. Beyond the surface differences of our own politicians – where largely culture-war issues like gay marriage and climate change policy mask unity on important matters such as the budget surplus and foreign policy – Hollande and Sarkozy offer starkly different visions of politics, economics and France’s role in Europe and the world.

Yet here too the appearance of la difference belies the likelihood of institutional status quo. The most extreme of Hollande’s positions – a marginal tax rate of 75% on incomes above €1 million – will have so many clauses that even the most inelegant loophole jumper on the 7th arrondissement will hardly be impacted. And Hollande's proposal to bring the retirement age back down to 60, among other things, will only impact a minority of workers.

Most important policies are, after all, now decided in Brussels, where the EU's unelected executive, the European Commission, has exclusive powers to propose Europe-wide legislation, uphold treaties and implement decisions. Both Hollande and Sarkozy are vehemently pro-Europe, with perennial third-party candidate Marine Le Pen taking the Eurosceptic heat out in the first round, to continue in the ideological echo chambers of right-wing blogs, anti-globalisation protests and Le Figaro’s editorial page.

And after all, for investors, the most important policies are decided by the equally-unelected executive board of the European Central Bank, which meets in a room with orange carpet high above Frankfurt’s Bankenviertel. And it is there, a final eyrie of hawkishness in a world of cheapening currency and accommodative policy settings, where the price of Italian government bonds, the solvency of Spain’s government and the unemployment rate in Greece, Denmark and Germany will be most impacted.

For Eureka Report readers, the arcane ideological battles between those like outspoken financier George Soros, who favours loose monetary policy in Europe, and German economist Jörg Asmussen, who next month will replace Jürgen Stark as the ECB executive board member responsible for economic analysis, will matter more than the dirigisme of François Hollande or the anti-entitlement-ism of Joe Hockey and Tony Abbott.

Similarly, it is the power struggle in Beijing’s politburo that matters perhaps even more than the outcome of November’s presidential election in the US, now that Mitt Romney looks set to offer a moderate face to the Republican candidacy (see China's ides of March and Lifting China's mask). And it is also in the equally opaque world of Chinese central banking where monetary policy worldwide will be most impacted, considering that despite a currency peg, China was where 52% of new M2 money was created last year.

Meet Helicopter Zhou'¦
Source: Standard Chartered, Bloomberg

But perhaps more than ever, the second half of calendar 2012 could be most affected by events in the largely autocratic states of the Middle East, as was the first half of 2011 when the so-called Arab Spring erupted from riots in what was seen to be relatively stable Tunisia. Beyond last week’s killing of a protester in Bahrain, which threatened to derail Sunday's Formula 1 race, tensions remain high in Iran, despite recent talks with UN Security Council states and Germany.

Questions too continue to be asked of Saudi Arabia's ability to produce more oil, should Iranian supplies be taken off the market, while fresh violence in Syria has discredited the UN's monitoring mission. Brent crude prices hover obstinately near the $US120 a barrel mark and notwithstanding the future promise of natural gas and shale oil, conflict over oil supplies from South Sudan to Argentina remain the present reality.

With events being unpredictably determined by unelected decision-makers, it is perhaps a good time to reconsider your hedging strategy if you have not done so already. While the dearth of democracy and the inefficiency of global markets should be nothing new – plus ça change – there has been a definite shift in the pattern of asset class correlations as the world has moved from the post-crisis stage of the 2008 crash to the 'new normal’ of deleveraging, austerity and a growing disconnect between labour and capital (see Age of extremes and Megatrends).

This pattern shift can be vividly illustrated by a series of heat maps from HSBC, produced as part of a study on the 'RORO' phenomenon (i.e. risk-on, risk-off), which has alternately annoyed and delighted fundamental investors and technical traders:

Correlations then (most correlated to least)'¦
Source: HSBC

Correlations now'¦
Source: HSBC

Uglier than a central banker’s office carpet, the red in the picture above indicates what many investors intuitively know: correlation within major bond and equity markets has increased as correlation between equities and bonds globally (i.e. the blue areas) has decreased (see Correlation’s causation). Yet as HSBC also concluded, there are ways to dynamically hedge this phenomenon and meaningfully diversify your portfolio without being sucked into the robotic day trading of RORO.

In my view, one of the cheapest ways to do this at the moment is by going long the Australian and US (CBOE) VIX indices, considering that a lull in short-term volatility, both here and in Chicago, belies both a trend towards increased RORO and a dicey macroeconomic picture, described above and in my previous commentaries. By going long VIX, you can effectively insure yourself against what I see as the possible collision of developed market deleveraging with emerging market economic crisis, courtesy of both higher oil prices and a fixed asset investment-cum-political crisis in China. Further, by going long VIX you can also effectively hedge the risk of squeezed profit margins in American stocks, should higher oil in the short-term be timed with an end to medium-term corporate efficiency and productivity gains (for more on this, US analyst Doug Short has an intriguing perspective).

The S&P/ASX 200 VIX (ASX:XVI) is a convenient way to trade Australian market volatility, whereas a variety of VIX-based ETFs are traded on the NYSE. Structured products based around volatility and the VIX are also available to clients of various investment banks and wealth management firms and a number of fund managers also offer indirect exposure.

Volatility and more dynamic hedging have been subjects of great debate among investment luminaries such as Jeremy Grantham and industry publications such as Risk in recent weeks, but with VIX still, in my estimation, remarkably low at the moment, this classic hedge to an uncertain world seems as good as ever.

You might have little control over the goings-on in unelected chambers, but through smarter investing strategies you can always vote with your feet.