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I think this piece nails why we can be successful in partnering our
resources to assess political risk since political risk now dominates
the market sentiment.

Michael

From the current issue of the New Yorker:


The Financial Page

The Age of Political Risk

by James Surowiecki May 24, 2010

It seems crazy: the German state of North Rhine-Westphalia holds an
election, and Americans’ 401(k)s go haywire. But that’s not a bad
shorthand description of what’s happened to the stock market over the
past few weeks. What links the two is the Greek debt crisis and the
actions of Germany’s Prime Minister, Angela Merkel, the villain of
the story. When the scale of Greece’s problems first became clear,
she grudgingly agreed to help with a bailout. But in the spring
Germans started to ask why they should pay for Greek fecklessness and,
as elections loomed, Merkel began taking a harder line in her public
comments. The tougher she talked, the more skittish markets got. On
April 26th, Merkel gave a speech in which she said, “Germany will
help if the appropriate conditions are met,” making it sound as if
that help were far from a sure thing. The yield on Greek debt
immediately soared, and within days a rout was on. It may well have
been the most expensive “if” in history.
The European Union did eventually come through with a rescue package
for Greece and other beleaguered members, like Portugal, but the
markets didn’t calm down, rallying on Monday only to nosedive again
at the end of the week. The fact is, this kind of volatility isn’t
going away, because we now live in an environment dominated by what
economists call “political risk”—the uncertainty that businesses
face as a result of government actions. Of course, government actions
always affect the economy, but usually in an undramatic way: an
interest-rate cut here, a new regulation there. The economic downturn
and the debt crisis have given us instead a world where governments
are among the most important players in markets—injecting money into
economies on a colossal scale and routinely propping up, or even
nationalizing, troubled companies.

As a result, investors have a vast range of new things to worry about,
like voter sentiment in Westphalia. They have to try to figure out
whether policymakers will do things they shouldn’t, like slash
spending during a downturn, and not do what they should, which is to
intervene promptly when systemic crises appear. Unfortunately, this
sort of thing is inherently harder to predict than, say, how Procter &
Gamble is going to do over the next few years. Last week, Mohamed El-
Erian, the C.E.O. of the bond giant Pimco, sent a letter to investors
saying that “the new normal” is a world in which “the public
sector plays a much more influential role.” That’s a more uncertain
world and therefore one in which markets will be more volatile.

Political risk is hard to manage because so much comes down to the
personal choices of policymakers, whether prime ministers or heads of
central banks. And those choices aren’t always going to be
economically rational—witness Merkel’s recent tergiversations.
Similarly, the U.S. government’s failure to bail out Lehman Brothers
in 2008 seems to have been in part the result of Treasury Secretary
Henry Paulson’s desire not to be seen as Mr. Bailout. Investors,
then, are being forced to read the minds of policymakers—not
something they’re good at. Markets work best when there’s lots of
information available and a historical track record to go on; they
excel at predicting things like horse races, election outcomes, and
box-office results. But they’re bad at predicting things like who
will be the next Supreme Court nominee, as that depends on the whim of
the President.Also injecting uncertainty is the fact that, even when
politicians do the right thing, timing is all. Take the TARP bailout
plan. Congress rejected it the first time around, in the fall of 2008,
and the Dow fell nearly eight hundred points in a day. TARP passed on
a second attempt, but by then the damage was done: fear and risk
aversion had spread, and the stock market tumbled fifteen per cent
more in a week. The bill for the Greek bailout has ballooned as a
result of similar delay. In March, people were talking about a
commitment of twenty-two billion euros. By early May, the E.U. and the
I.M.F. planned to come up with a hundred and ten billion euros. Now
more countries need bailouts and the total cost is seven hundred and
fifty billion. The initial estimates were certainly too low, but, had
Merkel acted sooner, the bill could have been a lot cheaper.

Politicians do sometimes do the right thing at the right time, but
that’s no easier to foresee. In 1995, with Mexico teetering on the
edge of default and threatening to take down much of Latin America
with it, the Clinton Administration conjured up a back-door twenty-
billion-dollar loan bailout that stabilized the Mexican economy. In
1998, when Hong Kong came under attack from speculators who believed
that its currency and stock market were overvalued, the government
daringly put enough money into the stock market to send the hedge
funds packing. And, just last year, the Obama Administration’s
decision to stress-test the country’s biggest banks and require them
to raise capital from private investors, rather than simply
nationalize them, was instrumental in stabilizing a falling market.
But in each case it was far from clear that the action would really
happen—all three decisions were subject to vituperative criticism—
so unpredictability still reigned.

Political risk adds new complexity to markets, and, as Nassim Taleb,
the author of “The Black Swan,” recently said to me, “As the
system gets more complex, it becomes harder to forecast.” Claire
Hill, a law professor at the University of Minnesota, argues that
investors trying to manage political risk have historically moved
between extremes of “optimism and skittishness,” which sounds a lot
like the current situation. That doesn’t mean you should put your
money in gold; over time, even volatile markets can rise. But it
won’t be a smooth ride. ♦


Read more: http://www.newyorker.com/talk/financial/2010/05/24/100524ta_talk_surowiecki#ixzz0oYr8DyD4