Long Read  

Don't fear the bond market

Don't fear the bond market
(Photo by KENA BETANCUR/AFP via Getty Images)

It is difficult to know what Liz Truss was thinking as she formally resigned as prime minister, but it would be understandable if she found herself ruefully echoing the sentiments of James Carville, President Clinton’s strategist, who famously said “I used to think that if there was reincarnation, I wanted to come back as the President, or the Pope, or as a 400 baseball hitter.

"But now I would want to come back as the bond market. You can intimidate everybody”.  

While it would be overly simplistic to assign Truss’s meteoric fall to bond investors, the reinvigoration of ‘bond vigilantes’ and their role in the collapse of the second Conservative government this year raises an important question: what is the relationship between capital markets and politics?

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This in turn gives rise to a second, and more practical question: how should investors think about politics when building portfolios?

These questions are inevitably tangled together, and so if we are to provide some useful answers, it is necessary to focus on the investor.

While some investors may have a short time horizon, those saving for, or near, retirement are likely to have an investment horizon of 20 years plus.

The key driver of the returns the investor receives over this period will be the growth in the cash flows of the companies in the portfolio.

This, in turn, will be influenced by the economic development of the countries in which those companies operate – development that will be shaped by the political decisions made by the governments of those countries.

As Ray Dalio has convincingly argued in his book The Changing World Order, investments in education, the promotion of egalitarian society and parsimony in government spending can support the long term economic growth of a country, leading to higher expected returns for investors in that country.

Equally, the opposite is true, poor education coupled with significant wealth gaps and excess government spending can lead to wealth destruction, often through conflict.

A short-sighted view

While this may encourage us to think about politics when making investment decisions, the glaring weakness in the above answer is that neither investors, nor governments, typically have the patience to wait multiple decades for results.

In contrast, both investors and governments are often fixated on short-term results, whether it be the quarterly performance numbers or the most recent opinion poll.

This ‘temporal myopia’ is most prevalent when we feel under threat as a result of being surprised by an unexpected outcome.

A surprise tends to provoke one of three predictable behaviours, known as the ‘fight, flight or freeze’ response.

These instinctive responses can result in mistakes that have long-lasting consequences and set off a chain of events that both magnifies the original mistake and creates a feedback loop that leads to further surprises and further mistakes.

In extreme circumstances, these feedback loops can impact the real economy, the actions of central banks and policies of government, leading to further moves in asset prices that perpetuate the cycle.

The importance of the linkage between the real economy, politics and capital market was recognised by George Soros in the last century and has been well described by his theory of reflexivity.