The Business Times, Friday 13 August, 2004

Investing goes beyond economics

Politics and history are just as important factors, says JOSEPH CHONG

GLOBAL equity markets have generally been trading sideways in a broad range over the past six months, despite headlines of strong economic growth. This apparent detachment when economic growth is very strong can often be explained by the stock markets' fondness for 'Goldilocks' conditions - not too hot and not too cold.

When an economy expands beyond its potential non-inflationary rate for too long, resources will be strained and an inflationary spiral may result. This would be negative for stock markets as we have revenue growth without corresponding profit growth. Moreover, stock market valuations will also be affected as higher sustained inflation will force an increase in the discount rate for equities.

On the other hand, if growth is weak, corporate revenues will be depressed. Given the difficulties of lowering labour costs, this will eventually result in a profit squeeze. Moreover, difficulties with corporate cash flows will result in elevated equity risk premiums. Hence, too low an expansion rate would also be negative for stock markets. Thus, stock markets perform best when economies are expanding moderately in line with their potential growth rates. The current fear in the market is that 2005 would be too 'cold'.

This is not out of order given that there is much uncertainty as a result of the withdrawal of monetary and fiscal stimulus in the US, the cooling of the Chinese economy, higher energy prices, and the reluctance of Asian economies to spur domestic consumption, among others.

Yes, economics has often been called the 'dismal science' because of the imprecision of predictions. Yet, almost every major investment house has an economics forecasting team. I reckon it is important to be least wrong.

Beyond economics

However, I do not believe that investing is only about economics. Human beings do not organise their lives around financial models alone. Jealousy, greed and fear drive economies and markets too.

For example, it has been established that one's happiness is relative to the perceived wealth of one's neighbours. Excessive income inequality could eventually lead to social unrest and nose-dive economies and markets. Wealth taxes are therefore not without a higher logic.

Indeed, I find that too much emphasis in research reports is placed on numbers. Very often, politics and historical forces which would have an impact on markets are either simply glossed over or ignored.

One example of this was the creation of the common European currency - the euro, which was modelled on the Deutschemark. This was expedited by the fall of the Berlin Wall in 1989, as Europe feared the eastward drift of Germany as its political and economic anchor.

It is this anchor of unity which gave Western Europe a long period of uninterrupted peace and prosperity - an eerie contrast to the slaughter and carnage of World War II, where some 30 million in Europe were killed (about 13,700 per day!) and entire cities destroyed.

The euro was therefore primarily a crucial political unity project that had to be undertaken despite its large economic impact. This was seen by its bringing about sharply lower bond yields throughout Europe outside of Germany through the 1990s. Investors who understood the history and politics of Europe would have enjoyed this mother-of-all bond rally.

A more current example is the price of crude oil and energy. Most of the analyses focus on the immediate supply and demand situation. This is important if one is a short term trader but an investor needs to figure out whether the price of oil, over the next five years will go higher or come off as it did in the past, back to US$20 per barrel.

Political considerations

Many studies on long-term supply and demand have been done but I believe political considerations will dictate the price of oil over the next few years. Firstly, both the West and Opec would not want the price to shoot through the roof from here as it would be damaging to the economies of the West and eventually Opec. High prices might eventually lead to permanently lower demand because of alternative energy sources and conservation.

On the other hand, it is also not in the interests of the West and Opec to have much lower prices, which could lead to economic hardship and social unrest in the Middle East. One could argue that the terrorism that we see today is a manifestation of anger against the perceived unfairness of globalisation which appears to perpetuate the dominance of the West.

Indeed, in the last century, the main facade for a more just world was the philosophy of communism. Maybe the silver lining of higher oil prices is fewer suicide bombings.

The influence of politics and history on economic development and markets has given us a soft spot for investment advisers and managers with a background in the humanities. Of course, being able to understand financial statements and economics is always a given.