Don't fear the bond market

"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?

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

Surprises that cause investors to make mistakes can also be a source of returns

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.

It is this reflexivity that so troubled James Carville. Demands for higher returns by bond investors, typically in response to an economic, policy or political surprise, can provide a strong incentive for policymakers to change course regardless of their democratic mandate.

The challenge for investors is that such reflexive outcomes cannot be accurately predicted ahead of time as the necessary preconditions for a reflexive move in market prices is a surprise that, by its very nature, cannot be accurately predicted.

To reduce the risk of a reflexive response, central banks, company management teams and even governments try to avoid surprising the capital markets by forecasting outcomes and their decisions as far in advance as possible.

However, surprises are far more likely in unusual economic, financial, or political environments, such as those we currently face.

In order to protect portfolios against these reflective feedback loops while accessing the long-term returns available to investors, we must maintain a dual perspective when constructing portfolios.

In practice, this means considering a wide range of potential outcomes when building a portfolio rather than becoming too invested in a single narrative of what the future holds.

By investigating the likelihood and impact of a variety of economic and market events on a portfolio, the investor is likely to be less surprised by a particular event and therefore less prone to mistakes, leading to a better outcome for investors.

Long-term focus

Alongside this focus on the robustness of the portfolio to near-term events, an investor must also focus on accessing long-term returns.

As investor sentiment dominates returns over the short term and economic fundamentals dominate returns over the very long term, the valuation of an asset tends to dominate returns over a five to 10 year period.

This is because anomalous valuations that result from the reflexive loops described earlier are unwound over time and consequently asset prices move towards their fair value.

With this perspective, it is clear that the surprises that cause investors to make mistakes can also be a source of returns if investors are able use the subsequent price movements to access unusually high long-term returns.

To do this, it is essential that investors have a clear expectation of the fair value of each potential asset, as this provides an anchor against which current prices can be compared.

This fair value will, in part, depend on the stability and quality of the political and economic backdrop of the country in which the investments are being made.

So while James Carville was right to fear the response of the bond market and the influence it can have on policymakers, the interaction of politics and capital markets can create opportunities for investors who are able to take a long-term approach and avoid being spooked by the bully boys of the bond markets.

Dan Kemp is global chief investment officer of Morningstar Investment Management