The End of Certainty

fuzzy diceThe last half of the 1900s was dominated by the Cold War: a geopolitical stasis predicated on mutually assured destruction. Investors, even the most progressive, restricted their investment universes to a limited set of capitalist countries, and the USSR stood as a compelling motivator for co-operation. The resulting stability made valuation both a necessary and sufficient tool for fundamental investors.

However, now and for the foreseeable future, the investment environment is fraught with geopolitical instability, and fundamental valuation is rendered necessary but no longer sufficient. Sufficiency requires the additional discipline of game theory, the analysis of leaders’ strategic negotiations where outcomes depend on both co-operation and conflict and where one leader’s choice of action depends upon the actions of other leaders. As such, the current environment is better understood, but not predicted, by studying the period from 1900 to the early 1930s.

The rise of game theory

Beyond fundamental valuation, investors need to not only use game theory to analyze and navigate national, regional and global negotiations but also deduce the asset-price implications of waning developed-country demographic dividends, waxing fiscal burdens and bloated central bank balance sheets. During the Cold War, the rising demographic tide hid a host of poorly conceived laws and regulations, but the receding tide will reveal which leaders can correct past mistakes and avoid future regulatory miscalculations.

Capital markets will reward strong leadership that supports competitiveness and trade. Complex interactions between developed and developing economies will provide global wealth creation and absorb risk. Over the coming decades, we could see moderately higher developed-country inflation, scaled-back social-welfare promises, increased global interaction and supportive regulation.

Such developments today, however, are hindered by policy uncertainty. During the 2008 financial crisis, policy uncertainty rose and has yet to return to the norm of preceding decades. This is the case not just in the United States but also in Europe and parts of Asia. Policy uncertainty impedes the resource-allocation decisions of economic agents globally and restrains equity returns. Despite the market’s perception that Europe is void of stability and that the U.S. is the only source of stability, the opposite seems to be emerging.

Policy uncertainty has been declining across Europe for the last couple of years but has remained high in the U.S., with the exception of fiscally motivated surges. This conventional wisdom could be reversed by equity prices that rise to fundamental values in Europe and stagnate in the U.S.

Brian Singer, CFA, is partner, head of dynamic allocation strategies, William Blair