Mapping the risks of bigger government

Bigger appetites for absolute return strategies, new attitudes to risk and governance, and the onset of major regulation – these were the forces for change identified in Watson Wyatt’s 2008 study, Defining Moments. But the social fallout from the financial crisis has sparked another phenomenon that could heavily impact institutional investors, according to Tim Hodgson senior investment consultant and founding member of the Thinking Ahead Group, who co-authored the paper. He spoke with Simon Mumme.

The role played by some of free market capitalism’s titans – prominent investment banks, insurers and some asset managers – in the global recession has caused many people to turn and reappraise the financial industry with a jaundiced eye.

When these same institutions were rescued by government bailout packages, and bonus pools soon reappeared, the public vented its anger.

“We are at the start of a multi-decade shift over what society defines as fair. In the US, it’s the AIG payments. In the UK, it was Fred Goodwin’s [$1.14 million] pension from RBS,” Hodgson says.

The public’s intolerance of what it judges to be unjustified rewards is one dimension of a major force that Hodgson expects will impact investment portfolios: public policy risk. This includes monetary and fiscal policy, financial regulation, economic stimuli, budget deficits and protectionism.

Society’s disenchantment with elements of the financial industry also feeds into the theme: it is encouraging governments to increase financial regulation and to reassess their faith in free market capitalism.

The public’s dissatisfaction “will drive government behaviour because they’re in the business of staying in power,” Hodgson, who is also a member of the investment practice’s global investment committee, says.

“At the moment, the battleground seems to be banks. And if you’re an asset management company tied to a bank, you’re caught up in it more than if you’re an independent asset manager.”

In Defining Moments, Watson Wyatt identified the increasing complexity within the institutional investment industry. Innovation within portfolios, such as credit default swaps, was accelerating as the social innovations of governance, in which pension funds organised themselves differently to make decisions. These dynamics are in a constant state of flux. And now public policy has become a contributing force.

So how can funds benefit from thinking about public policy risk? “For defined contribution funds, it becomes another extreme risk for which they monitor and develop contingency plans.

“For mature defined benefit schemes, not only are they interested in the kind of asset return implications, but what public policy would do to the shape of the yield curve, because it can shape return implications.”

Turning to dominant macroeconomic themes, Hodgson believes that the emerging wealth theme is of particular importance to institutional investors.

“We are in a long-term, relative decline of the west, and a relative rise of the east. That’s not to say the west is finished, but that it just won’t grow as fast as the levels our parents saw.”

While developing nations have long contained an ultra-wealthy minority, a far greater proportion of their populations are earning incomes that enable them to buy the consumer goods and make life decisions that are common in the west. For example, many can now buy televisions, cars, and send their children to university.

Most institutional investors are aware of this phenomenon, but acquiring a profitable exposure to it is difficult, and involves much risk. Hodgson says that nations’ currencies, if floated freely, provide a fitting entry point to their growth.

“Currency reflects rising productivity levels. Our thesis is that GDP per capita in these economies will grow more than in the west. Productivity will achieve this, and productivity should be reflected in exchange rates.”

Focusing on China, whose economy is still largely driven by cheap manufacturing and exports, in addition to state-driven projects, Hodgson is confident that the emerging wealth theme will be a long-term opportunity, and that the nation’s economic ascent will not be suppressed by the current rigidity of the state-driven economy.

Rather, the real threat to growth lies within its political system.

“China will do what it needs to. If it wants to be entrepreneurial, it will do it. But at the moment, they don’t have to tax their population. If the day comes that they do, the population may want a political voice in return.”

Currently, a single political party controls the nation’s economic future. But political plurality could sidetrack this advance, Hodgson says.