“Thirty years of hurt, Never stopped me dreaming...” (Baddiel, Skinner and the Lightning Seeds - 1996)
The drumbeat for the 21st World Cup nears. For a few blessed weeks, maybe less, we will dare to hope again - a statistically remote chance of raising the famous trophy, but never impossible? Suspending disbelief is an important part of supporting any team, particularly when your teams are Norwich City and England. Carefully calculated probabilities can help you guess at how many times your team would win if the game, or tournament, was played hundreds of times. As long as your team turns up, it will never be zero.
There is a useful lesson in this for investors; hope, fear, even greed can be deadly sins indeed when it comes to appraising investments. If a good decision should be based on a realistic assessment of the most likely outcomes, emotion severely hampers this process. The media doesn’t help, giving the most air time and column inches to the threats most likely to make us gasp (or just continue watching/reading) rather than those judged most likely. A recent survey in the US found that people ranked tornadoes (which kill about 50 Americans a year) as a more common cause of death than asthma (which kills more than 4,000) – presumably because tornadoes make better TV, making it easier for people to recall their risks – something our Behavioural Finance colleagues call the availability bias.
Investors are daily faced with a multitude of economic and geopolitical bushfires to assess. Most never develop into anything that warrants evasive action. A few do. The difficulty is not just that we of course have a very limited view of the future, but also that there is a penalty for being wrong in both action and inaction. History tells us that the world economy is simply much more likely to grow than not in any given month, quarter or year. The returns from capital markets, particularly stocks, tend to follow this trend unevenly higher. This is because, much like global output, corporate profits generally reach new all time highs on a regular basis, and as a result so will share prices and (reinvested) dividends. This means that excessive caution with regard to those various ever-smouldering bushfires can leave you underinvested in a market that tends to rise over time a lot more often than it falls. On the other side, failing to protect sufficiently against one of the rare nightmares that actually becomes a reality can result in sharp and painful losses.
Generally, investors in a portfolio well diversified across industries and asset classes can take some reassurance from the fact that such losses have been temporary. Even those invested in high risk portfolios at the peak of the last cycle, before the worst recession and bear market in living memory, have now made their money back and much more – providing that they stayed the course. However, the experience would certainly not have been a relaxing one.
Investors have spent the last couple of weeks grappling with exactly these dilemmas with regards to Italy. The still indifferent state of the Italian economy, allied to a surge in immigration, has provided populists and forces ambivalent or worse to the EU with rich stump box fodder. The Italian constitution still makes an exit from the EU a very unlikely eventuality, but recent months have certainly increased that small probability a little.
Nerves will continue to jangle over the summer. This new Italian administration does not look destined for old age, much like the other 65 governments that have come and gone since 1946. It will be vulnerable to the tactical considerations of current junior coalition partner, the League, who will be keeping a close eye on the polls, perhaps opting to walk away and invite fresh elections if they see their support continue to rise as it has in the last few months. Even without this threat, this is a coalition with a precarious majority in the senate, incorporating a broad spectrum of often conflicting political ideologies. We should be prepared for fresh elections in the not too distant future.
In such an eventuality, the debate about Italy’s membership of the EU and the euro will surely get another airing. In the meantime we could well see this more combative administration loosen the purse strings sufficiently to ramp up the national debt pile to ever more unsustainable levels. A showdown of the sort Greek authorities forced with the EU could ensue: this time with one of the world’s largest borrowers, rather than a capital markets minnow.
Throughout this, the most important thing for investors will be to have the appropriate information, context and perspective at hand. It will be important to remember that the Italian constitution, enacted in the ashes of Mussolini’s destructive reign, was deliberately designed to make future governments weak and policymaking protracted. Similarly, the constitutional barriers to even asking the Italian electorate a binding question on the country’s membership of the EU remain formidable, with two parliamentary supermajorities standing in the way.
For now, the Italian economy’s problems remain chronic rather than acute. In the context of a world economy that seems to be moving past its first quarter pause for breath, this means that portfolios should not shy away from risk to benefit from a continuing uptrend in corporate profits. This still means owning continental European stocks within a diversified asset allocation in our opinion. The probability of Italy opting to leave the EU within the next year is not zero, but the availability of opinions on this likelihood shouldn’t be taken as an indication of that probability growing. We still think it is a lot less likely than England winning the World Cup in Russia – which should put it into perspective for you.