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June 22, 2011, 12:01 a.m. EDT
By Matthew Lynn
LONDON (MarketWatch) "â? Are the Greeks bust, or can the euro struggle through this crisis? Will the United States ever get its budget deficit under control?
Will central bankers around the world launch another round of quantitative easing to refloat the markets or will they instead wake up to the threat of inflation and start raising interest rates?
Are the Chinese going to revalue their currency and finally start closing the massive trade imbalances between the developed and the developing world?
Those are probably the most pressing questions facing investors right now. And they are the issues which, depending on how you view them, will determine whether you conclude the markets look fairly valued right now, or undervalued, or are perched on the edge of a cliff ready for a full-scale collapse.
Professor John B. Taylor from Stanford University says the recovery of the U.S. economy is more dependent on sound fiscal policy, rather than stimulus spending.
And yet, the interesting theme that unites all of them is that they are all political rather than economic issues.
Anyone deciding where and how much to invest is used to studying issues such as corporate profits, trade flows, medium-term economic growth, and technological advances. They are the factors that traditionally determine how the markets move in the medium-term.
But right now, none of those matter nearly as much as the big political questions. Investors need to catch on to that. And they need to learn a whole new set of principles to steer them through how the markets will develop in the year ahead.
In the past, economics usually determined where the markets were going. You needed to figure out how much the economy was likely to expand, which sectors within it were likely to grow the fastest, and how the spoils of that growth were going to be split between wages and profits. You probably needed a fair idea as well of what technologies were developing quickly, and how they were going to impact companies. And you needed to get a sense of how different countries and continents were growing against one another. Once you'd figured out all that, then you could start to take a view on where you wanted to put your money to work.
That's changed. Politics is now firmly in the driver's seat. There are two big reasons for that.
First, governments and central banks between them have become the driving forces in the economy.
When deficits are running at 5% to 10% of GDP as they are in most of the developed world; when banking systems have become entwined with government, either directly or indirectly; and when central banks have embarked on massive programs of printing money, then the decisions made by politicians become crucial to the markets.
Next, we are going through a period of massive change in the currency markets.
The euro was an ambitious attempt at merging 17 national currencies into a single one. It now looks to have failed, and its gradual unraveling is going to be very messy. And the dollar is in long-term decline as the global reserve currency. Sooner or later, a new currency system will emerge. But while that is happening, the decisions made by politicians will be crucial to how the markets develop.
It may be good or bad "â? and in the opinion of this columnist it is certainly the latter rather than the former "â? but that is a debate for another day. That is the way it is. And given that, you need to steer your portfolio accordingly.
So what principles should investors keep in mind to guide them through a politics-dominated market?
There are three big ones.
One, watch the electoral rather than the earnings calendar.
What happens to corporate profits doesn't matter nearly so much as it might do in more normal times. The electoral cycle is more significant than the business cycle. How will that play out in practice? Well, you probably won't see any movement on the U.S. deficit until after the 2012 presidential election. Until then, there will just be uncertainty and confusion. Likewise, you won't get any movement on the French deficit "â? which, in truth, could make it the next victim of the sovereign-debt crisis "â?until we know whether President Nicolas Sarkozy stands a chance of being re-elected.
Two, figure out where the votes are.
In politics, nobody does anything that costs them re-election. Leaders live in fear of some group of floating voters in Hamburg or New Hampshire who might suddenly cast them out of office and leave them with nothing better to do than write their memoirs. So it doesn't really matter how many bankers or economists write learned articles saying that Greece needs massive fiscal transfers if the euro is to survive. It isn't going to happen, because if it did, German Chancellor Angela Merkel could say "auf wiedersehen"? to her job.
Three, expect muddle and delay.
When a decision has to be made by the government, it is never done quickly or cleanly. Politicians broker deals, they make compromises and they cut deals. In their trade, that is how you get to the top. It is usually the one thing they are really skilled at.
So don't expect the euro crisis to be resolved one way or another any time soon. It would be better if it was, because the uncertainty is hitting investment, spreading unease about the banking system, and is going to damage growth for the next few years. Still, it isn't going to happen. Europe's leaders will dither and delay, and try and kick the hard decisions into next month or next year, because that is the way they are used to dealing with things. And it would be better as well if the Chinese leadership decided the grasp the moment, and turn the yuan into a floating currency. But hard decisions are not what they specialize in.
For the moment, put aside charts of profitability, or valuations of bonds versus equities. All that counts is how the politics of the next year unfolds. And that means more volatility, more uncertainty "â? and markets that moves sideways for at least 12 months.
Matthew Lynn is a financial journalist based in London. He is the author of "Bust: Greece, the Euro and the Sovereign Debt Crisis," and he writes adventure thrillers under the name Matt Lynn.
"Fed trims economic-growth forecasts for 2011 and 2012 http://on.mktw.net/kHA5QA" 1:02 p.m. EDT, June 22, 2011 from MarketWatch
"Fed said today that recovery will pick up later this year as it has kept interest rates at historic lows http://bit.ly/lC4ii1" 12:25 p.m. EDT, June 22, 2011 from MarketWatch
"U.S. stocks mixed after Fed rate announcement http://on.mktw.net/ldGSBb" 11:50 a.m. EDT, June 22, 2011 from MarketWatch
"Pimco's El-Erian foresees Greek default: report http://on.mktw.net/lBZolI" 11:36 a.m. EDT, June 22, 2011 from MarketWatch
"Fed holds line on rates, reiterates planned conclusion of 'QE2' http://on.mktw.net/jXzyP2" 11:30 a.m. EDT, June 22, 2011 from MarketWatch
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