Former U.K. Prime Minister David Cameron met with a small group before his speech at CFA Boston’s Annual Market Dinner. It was inspiring to speak to a political leader who offered a balanced and well-informed perspective about the world’s policy challenges. Cameron’s objectivity was a welcome contrast to the polarizing approach that dominates political debate today, with far too many politicians framing complex issues in black and white terms.
Government policy historically was an important investment consideration only at major inflection points for fiscal, monetary or regulatory policy. Absent a major inflection point, government policy was typically subordinate to other investment considerations. The global financial crisis was game-changing, as government and central bank actions created market distortions that investors ignored at their peril. In the aftermath of the crisis, many major investors added significant analytical resources devoted to public policy issues.
Trade policy was a major factor influencing markets in 2018 and the initial weeks of 2019. Uncertainty about trade and supply chains is one of the causes of the recent economic growth slowdown. Worries about trade tensions were a major factor in December’s market downturn, while optimism about a potential trade deal between the U.S. and China contributed to the rebound to start 2019.
The natural tendency may be to react emotionally to headlines about divisive policy issues, but Cameron’s pragmatic mindset is a positive example to emulate. An analytical approach to thinking about the potential investment implications of different policy initiatives includes the following three steps:
1. Incorporate the “outside” view: Nobel Memorial Prize winner Daniel Kahneman’s “Thinking, Fast and Slow” is a helpful guide to decision-making, as is work by investor and Columbia Business School adjunct professor Michael Mauboussin. In Mauboussin’s words, “Are there similar situations that can provide a statistical basis for making a decision. There is considerable information out there. … Rather than seeing a problem as unique, the outside view wants to know if others have faced comparable problems, and if so, what happened.”
Investors who considered past experience were unsurprised at the initial results from the imposition of steel tariffs. According to Commerce Secretary Wilbur Ross, U.S. steelmakers added about 1,000 jobs since the imposition of 25% tariffs on imported steel. Unfortunately, steel consumers paid a steep price for the incremental boost in steel employment. The cost to four major users of steel — Ford, GM, Caterpillar and Whirlpool — estimated that tariffs cost them more than $2 billion. Retaliation to steel tariffs also created a consequential impact apparent to those who studied the outside view: China shifting most of its soybean purchases from the U.S. to Brazil. The resultant fall of nearly 20% in U.S. soybean prices made American farmers a casualty of the early skirmishes in the trade war.
The outside view is also relevant for investors considering the implications of policies gaining favor with progressive politicians. Wealth taxes aren’t a new phenomenon, and an examination of recent experiences with a wealth tax in France may provide valuable insight. There is also considerable historical data about the implications of high marginal tax rates on economic growth and investment returns. The Beatles song “Taxman,” inspired by the high marginal tax rates of mid-1960s England, is a cautionary reminder of a period of time in which the country was known as the “sick man of Europe” because of poor economic performance.
2. Focus on constraints rather than preferences: Political rhetoric can be both appealing and distracting, but too often there is a profound disconnect between rhetoric and reality. BCA Research offers a helpful approach to thinking about likely outcomes of geopolitical policy alternatives. BCA’s belief is that geopolitical decisions are typically shaped by constraints rather than by preferences.
Donald Trump has frequently changed political positions during his life as a public figure. However, his stated beliefs on trade have been consistent throughout time. Although Trump might strongly “prefer” to escalate trade disputes with China for the remainder of his first term as president, the risk of higher unemployment and lower economic growth creates a binding constraint that will force him to deviate from his personal preference. The constraints on Trump are likely to provide sufficient motivation to negotiate a trade deal to temporarily de-escalate trade tensions with China. China’s president, Xi Jinping, faces his own set of constraints that provide incentive to enter into a face-saving deal.
In one of many signs that fiscal austerity is “out” and fiscal stimulus is “in,” the proposed “Green New Deal” to combat climate change comes with a trillion-dollar potential price tag, as do proposals to create a single national health insurance program in the U.S. Some proponents for a dramatic increase in government spending cite Modern Monetary Theory, which suggests the U.S. can spend as much as it wants because it issues debt in its own currency. However, even the massive U.S. checkbook is subject to very important constraints. Inflation became a huge problem for the U.S. in the 1960s and early 1970s, a byproduct of spending on the Vietnam War and Great Society programs. More recently, out-of-control spending in Venezuela, Zimbabwe and Argentina led to economic crisis. The other potential spending constraint for the U.S. is the need to borrow heavily from foreign sources to finance deficit spending.
3. Assess the probability of different outcomes: University of Pennsylvania professor Philip Tetlock is the co-creator of the Good Judgment Project, and the co-author of “Superforecasting: The Art and Science of Prediction.” Among the lessons from Tetlock’s research is the importance of probability-weighting different potential outcomes. He encourages forecasters to find the right balance between inside and outside views, make a prediction, assess the reliability of that prediction and fine tune the prediction as circumstances change.
Today, investors consider the likelihood of a trade deal to be reasonably high and market prices have adjusted to reflect that high probability. Similarly, the consensus is for the Fed to slow their pace of tightening, with interest rates and earnings multiples adjusting accordingly. Proposals to impose wealth taxes, limit stock buybacks and establish a Green New Deal stake out policy positions in the early days of the 2020 election campaign. The proposals have had greater media impact than market impact, as with Donald Trump as president and a GOP majority in the Senate, the odds are low that any of the proposals will become law. The importance of fine tuning today’s probability-weighting will be high as the 2020 election draws closer, as the prospects for different policy initiatives could change dramatically.
The experience of the past decade shows the importance of policy to markets. Following a systematic approach to assessing policy initiatives can help remove emotions, helping investors make better-informed decisions.
Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston.
Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds.
Daniel is a graduate of Brandeis University and earned his MBA in finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco. He also sits on the Board of Trustees for the Green Century Funds.