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Investing a game in theatre of geopolitics

Glenn Freeman  |  24 May 2017Text size  Decrease  Increase  |  

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Applying principles of game theory to global investing can provide a framework for navigating through macro-thematic headwinds of geopolitical risk, says the portfolio manager of dynamic allocation strategies at fund manager William Blair.

 

Despite the French election result, which saw the centrist candidate Emmanuel Macron soundly defeat the right-wing populist Marine Le Pen, populism is not going away any time soon, says Thomas Clarke, portfolio manager, dynamic allocation strategies, William Blair.

"Geopolitical risks and macro risks arriving out of the populist wave are not going away. They will still be very important for some time. I think the only thing that will see that off, at least in the medium term, is a few years of robust, inclusive growth across the world, which we're not really getting yet ... you can't write off populism," says Clarke.

"The important thing is that everyone seems to agree that it's a problem, but no one agrees on what to do about it. How can you incorporate it into an understanding of the markets, and to investment decisions ... other than being something you've got to be scared of and get out of the way of?"

In response to such volatility, he views such scenarios that contribute to market volatility as "game theatres ... in a multi-player negotiating exercise," where various game participants--such as country leaders--are competing by using the different tools at their disposal.

As an example, Clarke refers to the 2016 Brexit vote and the referenda that preceded it, "where you had two players--stay and leave--they want opposite things, so they can't both win".

Ahead of the result, to determine who is more powerful, he says opinion polls are often the best predictor, though in this case they were "about even".

"The novel thing about geopolitics as it relates to markets is that the actors in the game share a mutual incentive to deliberately increase risk ... to create uncertainty that wouldn't be there otherwise."

In the case of Brexit, "they issued threats, bluffs, warnings, forecasts of bad things happening if they don't win and the other side does ... to replicate the type of uncertainty that markets hate and run away from."

"It's not really trying to predict the future, not trying to get information that no one else has got, but just trying to organise the same information everybody has in a way that is more relevant for interpreting investment implications.

"Understanding that helps you to determine whether various things will assist a price of currency moving to its fundamental value, or will it get in the way of that."

Exchange rates as an anchor

Clarke's outlook on currency is underpinned by a belief that currency exchange rates have fundamental values, grounded in purchasing power parity and carry rates, which are real interest rates.

"Knowing that currency rates have a fundamental value tells you the first thing you need to know in a world of uncertainty, which is, where medium-term opportunities actually are," he says.

He refers to charts that track exchange rates over a 30-year timeframe: "Over medium to long terms, in real terms, exchange rates don't really go anywhere, they go up and down, but they revert to a central tendency."

In the case of the British pound, he says William Blair saw the Brexit referendum as driving down its value, "and as an investor, that can be really useful--instead of saying 'now I just need to get out of having any exposure here,' you can view two clearly defined elements."

One is fundamental: that the currency value will decrease. The other is based on a geopolitical outlook, and that suggests the currency will decrease as well.

"You can then say they're aligned, so I'm going to be short the pound, and I'm going to take a more aggressive view because of the geopolitics."

Brexit and Trump, pound, and peso

"With the Brexit referendum ... something needs to tell you before February of last year, when the referendum was called, that the pound was starting from a position that was fundamentally unattractive and expensive ... that is essential to know before you worry about the face-off of stay versus leave as an additional negative or positive on top of that," Clarke says.

Similarly, he refers to the potential risk or opportunities some investors were eyeing in the Mexican peso ahead of Donald Trump's election win.

"Before you started to worry about Donald Trump, and the wall, and NAFTA, and tweets, you want to know which side of the price the inexorable gravitational pull of fundamental value is working, and you can't just look at the history of dollar-peso to work that out."

He says that ahead of the US election, the currency was fundamentally attractive, but for those considering buying in at that time, "you have a risk of a development that will basically be a growth negative for Mexico if it came to fruition, so it's making that opportunity riskier, less compelling ... Trump does get elected, he's tweeting about NAFTA and the wall, and the peso drops to an all-time low".

"Now it's very, very attractive; Trump is still president, but the event risk is over," Clarke says.

Using the analogy of an avalanche on a snow-covered mountain: "When the snow has fallen to the bottom of the mountain, it looks very messy, but actually when the snow has fallen down, the risk of an avalanche is lower. And using that analogy to Mexican peso, that's when you can get in, when this risk is sufficiently compensated."

"With the move towards renegotiating NAFTA rather than just ripping it up, this then created the opportunity to step in," he says.

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Glenn Freeman is a senior editor at Morningstar.

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