Portfolio positions and politics

Marko Papic is partner and chief strategist at Clocktower Group (an alternative-investment group) in California. Growing up in Yugoslavia, a country that no longer exists, he developed an early interest in geopolitics, an interest he honed while working for Stratfor - a company dedicated to making geopolitical risk assessments. This was followed by a career at BCA Research - another path-breaking research outfit where he started the desk for geopolitical inputs in portfolio strategy. All this expertise in geopolitics has been documented in a book titled 'Geopolitical Alpha: An Investment Framework for Predicting the Future'. As India heads into multiple important state elections, domestic politics will again reflect on short-term market gyrations. A look at the framework can be useful for investors in this context.

Geopolitical analysis is no longer 'nice to have' - it's essential
Papic suggests that macro investing has, for long, been about getting the credit cycle right - and in the global context, he is right. An 'independent' central bank mandated with setting interest rates to manage inflation and growth, a preponderant acceptance of 'laissez-faire' policies - small government, counter-cyclical monetary policy - and politics wasn't something long-term investors worried about. He calls this the 'Washington consensus' - policies that the IMF and World Bank were happy to peddle around the world. Since 2009, the world has shifted to dirigisme policies, which Papic dubs as the 'Buenos Aires Consensus' - with pro-cyclical fiscal and monetary policies, big government (what's fiscal profligacy, eh?) and de-globalisation. Central bank independence has been subdued by a need to tailor policies suited to what voters want - and they don't want economic pain, even for the short term. The role of political leadership in setting economic policy is now dominant and so is the need for investors to understand its role.

A framework of constraints
Papic doesn't suggest that investors should listen to recently retired policymakers or policy wonks to guess at policy direction. Nor is it necessary to meet the second cousin of the nephew of the political leader in power in smoke-filled rooms to figure out policy direction. In fact, quite the opposite. He suggests that little is to be gained by studying the pronouncements or 'preferences' of political leaders - instead, what needs to be studied is the 'constraints' that leaders work under. "Preferences are optional and subject to constraints, whereas constraints are neither optional nor subject to preferences." This framework of analysing politics offers a more predictable method of forecasting policy actions.

What is the 'constraints framework'? The first leg is that 'material constraints' are most relevant. No matter the ideas that a leader professes, his actions will be determined by what is materially available. The second is an understanding that information will always be incomplete. Relevant information is that which allows an analyst to diagnose ('diagnosticity') which of the two competing hypotheses is more likely. And the third is what Papic calls 'fundamental attribution error' - where conclusions are drawn based on the 'person' rather than situational constraints.

As an example, Greece remained within the EU (post-2009). Leaving the EU may have been theoretically attractive (devaluation of the currency could have increased exports/tourist inflows) but the reality of a poor manufacturing base and the likely time it would take for unpopular reforms to clean up the economy prevented the exit - a material constraint.

Constraints that matter
Material constraints can come from politics, economics, markets, geopolitics, the law or simply time. Looking at political constraints, the first constraint that Papic mentions is one that is hard to quantify or measure precisely - he calls it 'political capital'. He postulates that this is made up of popularity (approval ratings are a measure), time in power (the longer a leader serves, the lower will be this factor), legislative maths (does the leader have room to pass laws?), economic context (crises allow reforms but don't benefit the incumbent), special-interest-group support (groups that mobilise to pressure the government, have an advantage over the rest of the population) and global momentum (global tailwinds provide for easier policy changes in the same direction).

Another political constraint that is important is the 'Median Voter Theorem' - an election win is more likely for a party whose policy choices are closer to those of the median voter. This assumption is simplistic in that it assumes that voters prefer one policy over a range of possible outcomes, but it still provides a way to model voting preferences. Political parties move their preferences towards where they think the median voters' preferences are - irrespective of their own ideology.

Other constraints are similarly described but are relatively easier to understand.

Using the framework
The book is replete with examples of how the framework can be used to make portfolio choices. Papic made a bullish-market call within a couple of months of COVID striking. He based it on the macro move to dirigisme policies - where deficits don't matter. Similarly, his framework posits that in a multi-polar world, countries 'cheat' with each significant power looking out for itself and 'leading nations' unable to keep their 'flock' together. This, for example, explains why the US cannot avoid trading with China because any attempt to impose trade restrictions beyond a point would lead to its allies using the opportunity to expand their own relationships.

The policy framework, though interesting, is not without its limitations. It is not easy to quite understand which constraints are material and what the relative power of competing theories is. Even if predictions are directionally correct, for them to be useful, the timing of market action too needs to be within the predicted time-frame - something not trivial to achieve. Papic devotes a chapter to India where he explains why, in his view, the market would continue to lag - something that he got horribly wrong. That doesn't, however, take away from the general argument he makes about long-term constraints to India's economic growth.

Though an interesting and worthwhile read, the framework that Papic suggests is neither as robust as he makes it sound nor as unambiguous to personal interpretation. Despite that, it adds an important tool in attempting to analyse the effect of geopolitics on markets.

For the upcoming elections, it would be an interesting exercise for readers to identify what political capital exists for each party and what the median voters' policy preference is. While it may not necessarily lead to accurate forecasts, it is likely to reveal insights differing from analysis focused on caste equations and traditional voting patterns.