Despite threats ranging from North Korea to a government shutdown, the economy has accelerated and markets look buoyant. But complacency about political risk is itself one of the biggest risks the U.S. faces
Just how much political risk can the U.S. economy tolerate? Quite a bit, it seems.
The federal government could shut down in a few weeks for lack of a budget. It could default on its obligations if the debt ceiling isn’t raised. Trade treaties with Mexico, Canada and Korea may be torn up.
North Korea has tested an apparent H-bomb and threatened to use it. And overseeing these challenges is an unpredictable and often-divisive president with associates embroiled in an investigation over ties to Russia.
Yet economic growth has remained largely unperturbed and, judging by the latest gross domestic product numbers, may have even accelerated ahead of two major hurricanes. Stock prices remain near record highs.
The reason for the dichotomy is that the impact of political risk depends on the risk. Government shutdowns, protectionism, presidential scandals, even conventional wars have happened before and are thus knowable and sometimes quantifiable to businesses, consumers and investors.
Federal default or nuclear war fall in the category of unprecedented and unthinkable. Faced with such risks, the usual reaction is to assume they won’t happen. Yet that assumption becomes a risk in itself: It alleviates the pressure to prepare for either and multiplies the damage if they do occur.
The outbreak of the global financial crisis a decade ago ushered in an era of elevated political risk, as illustrated by an index compiled by the academic economists Scott Baker, Nicholas Bloom and Steven Davis that tracks mentions of economic policy uncertainty in newspapers. The U.S. mortgage meltdown was soon followed by the European sovereign debt crisis, a showdown over the U.S. debt ceiling in 2011, Britain’s vote to leave the European Union last year and the election of Donald Trump last fall.
Because political risk has been a constant, it has lost some of its shock value. Investors have in effect built that risk into their assumptions; their demand for safety is one reason government bond yields around the world are so low.
Since 2009, hedge funds as a group have positioned themselves for another meltdown like the subprime bust, says Jason Thomas, head of economic research at Carlyle Group , a private-equity manager. But “the same psychological factors that make ‘next subprime’ investment strategies seem more appealing,” he says, have also led businesses to favor cash retention or share buybacks over capital expenditure, and policy makers to regulate more. That depresses growth but also makes the economy less vulnerable to sudden shifts in sentiment.
As a result, hedge fund performance has suffered from strategies designed to profit from a meltdown that has yet to happen. With bearish psychology already so prevalent, actual selloffs have been brief and the VIX, the market’s so-called “fear gauge,” which is based on derivatives prices, has been subdued.
Those who watch politics and policy for a living—a sizable contingent on Wall Street and in Washington—tend to overestimate how many ordinary people do the same, and thus how much their behavior will change because of politics. In market economies, the natural rhythm of the business cycle easily drowns out politics. Big policy actions such as rising trade barriers or reduced immigration do take their toll, as the latest British data suggest, but slowly, not in a spasm of panic selling and recession.
What would overwhelm these coping mechanisms? Something previously unfathomable, like nuclear war.
No atomic weapons have been used since the U.S. dropped them on Hiroshima and Nagasaki. The public assumes global leaders won’t let it happen again. As Capital Economics notes in a recent report, the market barely sold off during the Cuban missile crisis in 1962, the closest the world has come to nuclear war since 1945.
A nuclear attack on a U.S. ally, city or electrical grid via electromagnetic pulse is so alien to a business’s frame of reference that it can’t be planned for. On earnings calls with investors in the past three quarters, big companies have mentioned tax policy 1,024 times, immigration issues 40 times, and North Korea just 14 times, according to Hamilton Place Strategies.
But North Korea may be a less rational actor than the Soviet Union was in 1962. Mr. Trump’s willingness to go to war is also being underestimated, says Marc Sumerlin, a former economic aide to President George W. Bush who runs Evenflow Macro.
To say there’s no military solution is to say Americans must accept living within missile range of a country whose leader may be unstable, he says: “That’s not as easy a decision for someone who’s taken an oath to defend the country as it is for someone sitting in a think tank.”
As with nuclear war, the assumption the U.S. won’t default is based on the fact that it hasn’t done so since 1814, at least deliberately. It delayed payment on some Treasury bills in 1979 because of a technical glitch. Its refusal to repay some bonds in gold in 1933 also is considered by some a type of default.
The Fed and Treasury in 2011 drew up contingency plans if the debt ceiling wasn’t raised to prioritize debt payments over other obligations such as Social Security benefits. Yet the deepening dysfunction of U.S. lawmaking means default by accident is a recurrent threat.
Political risk is part of a new normal. It takes its toll slowly and at the margin as decisions to hire or invest are deferred, rethought or resized. But until the unthinkable happens, don’t expect it to tank the economy.
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