Friday, April 14, 2017

Populism and the economic laws of not following budget constraints

There has been a tremendous amount of talk concerning populism and politics, but for investors the focus still has to be on the economic and market impact of these movements. Discount the news headline and rhetoric and focus on the potential market impact, but a good definition for populism is necessary for building a framework to determine risks.

So what is populism from the perspective of an economist? Populism, according to Sebastian Edwards and Rudi Dornbusch, two leading economists who have written on the topic more than two decades ago, is "an approach to economics that emphasizes growth and income distribution and deemphasizes the risks of inflation, external constraints, and the reaction of economic agents to aggressive non-market policies". The euphoria of populist change must be tempered by the reality that there are limits to change. The risk is whether reality will temper behavior or whether extremism leads to a crisis.

The reality of not following budget constraints and not using existing institutions is what defines populism in terms of economics. This applies to both left-wing or right-wing populist upheavals. Current institutions and budget constraints should temper extremes in government and thus in populism. A populist government often begins as one that upends existing institutions and does not feel constrained by budgets and thus creates the potential for economic dislocations. The question is how far will this upheaval go and how much stress will be placed on the economy.

From an investor's perspective, it is important not to follow the rhetoric but how budget constraints will be placed under stress and potentially broken. This is the risk that has to be assessed. If the government tempers its behavior to stay within constraints, there is the potential for markets to remain relatively stable. If there is pressure to break institutions and budget constraint there is the potential for large market dislocations. This is why we have focused on the two tailed risks of extremes at the begging of the year.

Some of the political extremism has dissipated since January, but given its potential, we would argue that both left and right tail-risk exposure management makes sense. There is value in divergent hedge fund strategies that will make money if there is movement to market extremes. These are priced low given the current low market volatility.

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