Global turmoil creates strategic opportunity

Geopolitical tensions from the rise of ISIS to Russian aggression present what one consultant calls a global instability premium that could drive strategic institutional investment allocations to non-U.S. assets.

“The global instability premium is the result of political instability in the world, causing investors to overallocate to safe harbors, creating opportunities in other allocations” in other regions, said Eric J. Petroff, president of Petroff Institutional LLC, Seattle, a consultant to institutional investors and money managers.

In addition, Mr. Petroff said, “We're in this period of massive amounts of monetary policies that has to be reversed. That is a source of instability.”

Mr. Petroff laid out his concept in a paper, “The Global Instability Premium,” posted March 11 on the Enterprising Investor blog of the Charlottesville, Va.-based CFA Institute.

Speaking about the global instability premium, James W Paulsen, Minneapolis-based chief investment strategist, Wells Capital Management Inc., said: “I think there is a lot of validity in it.”

“There will be times that the premium exists,” Mr. Paulsen said. “Right now, that is exactly what I'm doing. I'm looking to capture a perceived reduction in the global risk premium. If ... the global risk premium diminishes, you will outperform.”

But others don't agree that such a specifically defined premium exists or that a concept of instability should trigger allocation shifts.

“From the standpoint of being a long-term strategic investor, we don't take a tactical approach exploiting these short-term variations” in value, said Dennis D. MacKee, communications director of the $181.6 billion Florida State Board of Administration, Tallahassee.

“If you are a long-term investor, you ride through instability,” he said.

Matthew E. Stroud, New York-based head of investment strategy-Americas at Towers Watson Investment Services Inc., said the rising dollar and weaker economies in Europe and elsewhere are driving investment assets to the U.S. market.

“As far as the instability premium itself, what we see is a divergence across markets that ebbs and flows over time. Sometimes markets behave more as a closely packed group and sometimes you get very sharp separations, which is what we are seeing right now with the U.S. and Europe.”

“It's a very difficult thing to time,” Mr. Stroud added.

“We don't believe there is a structural premium per se for participating in instability beyond the general uncertainty that's already priced in the markets,” Mr. Stroud said. “The reason why there is an equity risk premium ... (is) there is always uncertainty, there is always risk.”

The instability is contributing to a capital flight to the U.S. market, perceived as the principal safe harbor, by both non-U.S. and U.S. investors, Mr. Petroff said.

The concept of a global instability premium is new, he said. But the question is, “Is the premium worthwhile taking?”

“The premium exists, but it is not large enough to rationalize an allocation” at this time, Mr. Petroff said, despite all the tensions as well as other risks, such as from monetary policy shifts.

But “given the way the world is going, unless there is a change (that reduces tension and monetary instability) the premium is going to increase. So there will probably be an opportunity sometime in the future,” Mr. Petroff said, without projecting a timeframe for action.

The non-U.S. markets show a “significant return premium” over the U.S. market, Mr. Petroff said.

“Not only (are) implied returns for global equities much higher than the S&P 500, but also their return premiums have jumped significantly during 2014, quite possibly because of growing military tensions and the political chaos that goes along with them.”

The strong dollar also is drawing foreign as well as domestic investors to the U.S. markets, both to bonds and equities, he wrote.

“So, from this perspective, international equities look even better if you believe the U.S. dollar's value will fall from its highs over time as the world works through its problems.

“Strategically, there is no compelling reason to pour assets into global equities for a short- to intermediate-term return horizon,” Mr. Petroff wrote in the paper. “However, that does not mean an opportunity will not present itself in the near term. The world is becoming a much messier and more dangerous place and seems unlikely to change course anytime soon.”

Mr. Paulsen said he still holds generally to his allocation recommendation made at the beginning of the year: for institutional clients to be “minimally exposed to U.S. equities and maximally exposed to global equities,” while having maximum exposure to equities overall.

“It's a variable you will focus more on,” Mr. Paulsen said, of the instability premium. “I don't think this is going away.”

“My advice is, you want to be outside the U.S. this year,” Mr. Paulsen said.

“A lot of consensus thought is ... to stay in the U.S. because the dollar has been so strong,” Mr. Paulsen said. “But year to date, most international markets have outperformed the U.S.” in terms of local currencies. “If their currencies pick up, that (outperformance) could become even more pronounced.”

Towers Watson considers instability in terms of geopolitical risk in its investment strategy analysis, Mr. Stroud said.

“From what we can tell, it's always there,” Mr. Stroud said. “It's big today. But it's always big. It's hard to make an argument that geopolitical risk is bigger today than it was anytime in the past.”

As a result, Mr. Stroud said there is “not necessarily” any allocation strategy to take advantage of it.

Even so, he said, “we are seeing the linkage between U.S. and eurozone equities ... weaker than it was” since the 2008 financial crisis.

”A lot of what we are seeing as far as instability of prices in the markets is in the currency markets,” Mr. Stroud said.

“The best thing to do is to spread your bets and make sure the risk you have from any one exposure or currency is properly sized and not so large that a really extreme move can cause a problem,” Mr. Stroud said.

Mr. Petroff said: “The global instability premium should exist only during certain periods of time. That's why we think we should be looking at this every quarter, because you never know something crazy might happen that could cause a spike that might be an opportunity.”

Mr. Paulsen said greater connections of markets and economies contribute to an instability premium.

“That has been exacerbated by an increasing linkage across global economies that didn't exist until about 10 or 20 years ago,” Mr. Paulsen said.

Today, “the U.S. couldn't even move its monetary policy independent of what happens elsewhere,” he said. “The impact (of the rising dollar value against the euro and other currencies) wouldn't have the strong impact 25 years ago because trade and other connections weren't as large as today.”

Mr. Paulsen sees the instability premium as a tactical opportunity — not a short-term trading opportunity but an opportunistic allocation for a few years at a time.

“There is nothing going on in the world today in character and magnitude that hasn't been out there throughout our history,” Mr. Paulsen said. ”There are geopolitical concerns and there always will be. What is different is the specific issues and ... the U.S. is smaller in relation to the global economy than it has ever been, at least in modern history.

“So we have a greater sensitivity to geopolitical events than we have ever had.”

The instability risk “is going to ebb and flow,” Mr. Paulsen said. “So there will be tactical moves.” n