Rules 1-5 in this series have focused on how the policy process mimics markets (Rule 2: The Trend is Your Friend; Rule 4: The Role of Economic Data) and how investment strategists must adopt the same rigor to analyzing policy developments that become public as they do to tracking market, company and economic developments (Rule 1: Be Objective; Rule 3: Be Strategic; Rule 5: Be Relentless).
This week, we start focusing on how public policy and the news cycle around public policy are different and what you can do about it. Welcome to Rule 6: Be Flexible.
Public Policy Risk is NOT Binary
The most important thing to understand about public policy risk is that it is not binary. This will initially sound counterintuitive. The news cycle encourages outside observers to view public policy as a binary event. Examples include: Did legislators vote for or against a law? Did voters vote for or against a particular referendum decision or candidate? Did leaders at a summit agree to take a specific action?
The temptation is great to treat these inflection points as triggers for investment decisions. Algorithmic and high frequency traders build entire automated execution strategies around headlines for this reason. The underlying, implicit assumption is that these policy data points are no different from economic data. A particular job growth number or CPI number or quarterly earnings report will hold specific and automatic second-order impacts on economic growth and a company’s bottom line at least for the next quarter or until the next data release…which occur at predetermined intervals.
Public policy risk is not that simple. It operates on a continuum. Decisions can be taken off-cycle, as the current Brexit situation illustrates. More importantly, public policy is more like software development. It is never really finished. A “final” vote or decision merely resets the deck for the next round of advocacy and policy planning, as the winners seek to maximize momentum to ensure their decisions cannot be reversed, and the losers start planning for how to regain lost ground.
Successfully trading the news requires a strategic perspective that sees past the immediate headline to the next few steps in the process in order to determine how solid the outcome might be. Treating a new development as a binary event often can result in trades that leave (or eliminate) the alpha potential.
Being nimble can be difficult, particularly in the face of overwhelming media attention to a specific inflection point. This is why high frequency traders automate the execution process. Unlike humans, a computer does not need to get past its emotional reaction to a development. It just sees the inflection point and takes the action programmed into its system. As we noted HERE recently, solutions that facilitate the translation of unstructured verbal data into structured numerical data deliver efficiency and analytical gains precisely because they provide an objective, unbiased mechanism for interacting with the news cycle that forces people to engage analytically rather than emotionally.
Inflection Points Are Real, But NOT Unforeseeable
Policy decisions may not occur on a set calendar like data releases and regulatory filings and annual meetings, but they can be identified in advance by applying a 360-degree view of the policy cycle.
Consider the last 24 hours (today being April 10, 2019). Yesterday, policymakers were preparing for major meetings in Europe in order to address the Brexit chaos. Finance ministers and central bank governors were convening in Washington DC for the Spring Meetings. And transatlantic leaders were reportedly preparing a fresh round of trade war tariffs in response to a favorable ruling for the United States at the World Trade Organization with respect to Airbus subsidies. The momentum picture looked like this at the start of the day today:
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That’s right – global trade policy was nearly as active as Brexit policy yesterday in aggregate. But the amount of concrete action regarding trade policy was far larger than for Brexit, even with all the pre-summit negotiations underway in London and in Europe.
Being flexible requires understanding when the noise of the news cycle obscures strategically significant developments and being ready to act on it. Brexit, of course, provides a classic example of the importance of being flexible, as well as relentless.
Case Study 1: As we noted in February, using our patented process, all policy indicators both in Europe and in the UK were pointing towards a No-Deal Brexit at the end of March. But as the deadline approached, policymakers on both sides of the English Channel sought extensions to the deadline to April 12. Current news reports indicate policymakers in Europe are flirting with a second, much longer extension (6-12 months) with conditions and restrictions.
The end of March came and went with No-Deal dominating the policy trajectory. But Brexit itself still has not occurred. Being relentless (Rule 5) in tracking developments and being objective (Rule 1) in analyzing those developments made it possible to spot the shift away from a definitive decision one week in advance of the March deadline for Brexit. Being flexible (Rule 6) meant accepting that the concrete facts were pointing towards two parallel and potentially conflicting outcomes simultaneously: continued No-Deal dynamics but no imminent exit either for the UK.
Being flexible means every day being open to the possibility that a prevailing policy trajectory can shift and reacting nimbly to that shift.
Why Being Flexible is NOT About Tracking and Executing on Headlines
Consider next the composition of activity regarding trade policy yesterday. Policymakers in the United States (the left pie chart) and the WTO (the right pie chart) were active on a much broader range of issues than just trade war tariffs and subsidies.
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Buried deep in the weeds of the United States trade policy arena yesterday, far away from the media spotlight, U.S. trade policy was accelerating its shift towards non-tariff barriers. As noted HERE and HERE, advanced economies dominated by services increasingly seek to focus on non-tariff barriers in the form of regulatory policy and standards in order to expand the free flow of services across economies.
The specific action was extremely technical and very strategically significant. But because it occurred outside the ambit of the WTO/Brexit media feeding frenzy, it was largely overlooked. Yesterday, pursuant to a bilateral trade promotion agreement with the United States, Peru reversed a December 2018 decision regarding the agency that oversees forests and timber concessions. The agreement required that the relevant regulatory body remain independent. In December, Peru had moved to incorporate the agency into the government in order to exert more political control over the entity. USTR objections pursuant to the bilateral agreement. Yesterday, USTR announced the Peruvian government had reversed course and the forestry regulator would remain independent.
While everyone else is chasing the Brexit and WTO headlines, two very specific sectors (timber, environmental issues) in a specific country (Peru) have solidified policy trajectories AND have signaled that the main driver of the decision is a bilateral trade promotion agreement with the United States. This is how alpha can be generated from a disciplined process for tracking policy developments comprehensively. Research into which US companies and which Peruvian companies stand the most to gain from this decision will generate trading strategies in the timber and environmental sectors that perhaps few are tracking based on cold hard data.
Being flexible means not only having a superior process for spotting the inflection point but also the willingness and ability to act based on the implied opportunity beyond (and sometimes despite) the headlines. Being flexible thus requires a 360-degree view of the policy process and understanding that policy often is made outside the glare of the media limelight and using tools that will provide more than just an aggregation of headlines that repeat the same information.
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