When buy and hold investing meets democratic backsliding
Adapting the principles of good investing for a destabilized era
Some of my Destabilized posts go deep on discrete pieces of a larger picture, and others try to generate new insights by drawing connections between disconnected spheres. Today’s piece is the latter. I hope it offers a new perspective on the financial implications of potentially worsening political instability.
In this period where the stability of American democracy is less certain, there are important questions we need to ask about the implications of this significant change. For example, will our financial markets show resilience in the face of upheaval to the same degree as in the past? Can the American economy remain strong if the rule of law becomes less dependable? To be clear, we’re not there yet. The rule of law is still alive and more or less well in the United States in 2022. The new question we have to ask is: how long can we count on that lasting?
In a recent report titled Is democracy failing and putting our economic system at risk?, Brookings scholars Bill Galston and Elaine Kamarck tackle this topic. Citing a number of studies that find a strong connection between democratic health and economic outcomes, the authors say:
The simple fact is that it is hard to plan and invest for the future in volatile, unstable circumstances. The United States is not exempt from the calculus of political risk analysis, even if we are not accustomed to applying it to our own country.
Moreover, as overseas firms and countries begin to worry about the stability of our laws and institutions, they will think twice about investing in the United States, and mutually beneficial international partnerships will be harder to negotiate.
…The fate of democracy and that of the private sector are inextricably linked, and private sector leaders have reasons of self-interest as well as principle to do what they can to strengthen democracy.
I agree with Kamarck and Galston that democratic backsliding would likely damage the U.S. business climate. I also strongly suspect an impaired business climate would eventually hurt stock market valuations. Even if it didn’t impact earnings – and it very well might – how could it not affect sentiment and therefore multiples? It undoubtedly would. The potential chain of causation would look like this:
Democratic backsliding —> Impaired business climate —> Stock market declines
The full chain matters, but given that the second and third stages are fairly likely to happen if the first one comes to pass, the big question, on which so much hinges, is whether democratic backsliding continues and how bad it gets.
In an Atlantic piece in December, Bart Gellman provided a detailed recounting of the lengths to which Trump and his allies went in their attempt to steal the 2020 election. He also looked at their efforts to lay the groundwork to steal the 2024 election. (If that sounds like an outlandish accusation, you should definitely read the article.)
The article is very good, I strongly encourage you to read the whole thing. It begins like this:
Technically, the next attempt to overthrow a national election may not qualify as a coup. It will rely on subversion more than violence, although each will have its place. If the plot succeeds, the ballots cast by American voters will not decide the presidency in 2024. Thousands of votes will be thrown away, or millions, to produce the required effect. The winner will be declared the loser. The loser will be certified president-elect.
The prospect of this democratic collapse is not remote. People with the motive to make it happen are manufacturing the means. Given the opportunity, they will act. They are acting already…
“The democratic emergency is already here,” Richard L. Hasen, a professor of law and political science at UC Irvine, told me in late October. Hasen prides himself on a judicious temperament. Only a year ago he was cautioning me against hyperbole. Now he speaks matter-of-factly about the death of our body politic. “We face a serious risk that American democracy as we know it will come to an end in 2024,” he said, “but urgent action is not happening.”
Gellman details the Trump team’s strategy and actions leading up to January 6th, 2021, when the electoral college results were to be – and ultimately were – certified. The upshot is Trump was stymied over and over by Republican officials who did their duty and refused to capitulate to pressure. This has often been framed as a reason to doubt such a brazen plot could ever succeed. But, as Gellman explains, that’s the wrong, backward-looking way to see it.
Since the 2020 election, Trump’s acolytes have set about methodically identifying patches of resistance and pulling them out by the roots. Brad Raffensperger in Georgia, who refused to “find” extra votes for Trump? Formally censured by his state party, primaried, and stripped of his power as chief election officer. Aaron Van Langevelde in Michigan, who certified Biden’s victory? Hounded off the Board of State Canvassers. Governor Doug Ducey in Arizona, who signed his state’s “certificate of ascertainment” for Biden? Trump has endorsed a former Fox 10 news anchor named Kari Lake to succeed him, predicting that she “will fight to restore Election Integrity (both past and future!).”
Threats of violence, a mainstay of Trumpist politics since 2015, are another malignant tool in this toolbox.
Death threats and harassment from Trump supporters have meanwhile driven nonpartisan voting administrators to contemplate retirement.
Vernetta Keith Nuriddin, 52, who left the Fulton County, Georgia, election board in June, told me she had been bombarded with menacing emails from Trump supporters. One email, she recalled, said, “You guys need to be publicly executed … on pay per view.” …Nuriddin said she knows colleagues on at least four county election boards who resigned in 2021 or chose not to renew their positions.
We don’t know what the world will look like in 2024,1 and we don’t know how the next presidential election will unfold. We must and will fight for our democracy, and we absolutely can succeed.
At the same time, we need to recognize the possibility that American democracy could be on its way out 36 months from now. If that happens, we need to understand the implications so we don’t get washed away in the cascade.
The most important thing to understand is this: the risks of political turbulence and democratic backsliding are not yet priced in. It’s not priced in on the downside for financial markets broadly, and it’s not priced on the upside for companies that would gain from upheaval and disorder. This creates two strategic investing opportunities: one defensive, and one offensive.
Below I offer three principles for sound investing in the context of what last week I called “Bucket #2 changes,” i.e. a world with greater political and climate-driven upheaval and uncertainty. The first two are fundamentally defensive, and the third one offensive. In the coming weeks I’ll be translating these into specific strategies and discrete actions, but it’s worth starting with the foundational principles.
[Note: what follows is for informational purposes only and is not investment advice.]
Compared with a standard sound investing strategy in the U.S. over the last 75 years, a good approach to investing in today’s destabilized context should be:
More cautious – When you’re driving on a road you know, you can go faster while still driving safely; when you’re on an unfamiliar road, you have to go a bit slower in order to maintain the same level of safety. There have always been unknowns and uncertainty in the world – always – but the world today, and especially the U.S., is less familiar territory than it was 20 years ago. Driving slower can mean a number of things, including holding more cash and countercyclical investments. (One complicating factor is U.S. treasuries are the prototypical conservative investment globally, but as the United States grows more turbulent we have to wonder if that will begin to change.2) At the very least, investors should consider whether a larger allocation to cash might make sense given their financial goals.
More diversified – Diversification reduces vulnerability to adverse events in a particular country, region, or industry. For example, Russians who were heavily invested in their domestic stock market3 have lost approximately all of that wealth in the last three weeks. (This concern is somewhat tempered by the fact that the U.S. stock market represents nearly 60 percent of the total market capitalization of public equities globally, and that many large U.S. companies have significant exposure to international markets.) More diversification is generally a good idea, and especially so for those whose investments are concentrated in the U.S. The benefits of diversification are meaningful and the cost, in terms of expected returns, are small to nonexistent. Bottom line: we shouldn’t put most of our investment eggs in the basket of a country whose democracy looks shaky.
Overweight antifragility – Businesses tend to benefit from predictability, and stock markets generally dislike turbulence. That’s why destabilization is an investment risk. However, this isn’t true for all companies and investment vehicles. Identifying and adding antifragile elements to your investment portfolio is a smart response to increased uncertainty. Because of the uncertain timeline, the best antifragile investments will be those that are solid in any environment, and that tend to gain from disorder. I’ll have more on this down the road.
Playing devil’s advocate for a moment, the strongest arguments against factoring destabilization into one’s investing approach are: A. it might not be as bad as we fear, and B. even if it is, it could take many years to play out, and if the stock market rises over that period you’ll miss out on the gains.
These are good and important points, full stop. Here are three responses:
Adjustments to investing strategies to account for destabilization should be incremental and modest, especially at first.
Even if it’s not as bad as we fear, the market is currently pricing in next to nothing. Marginal changes in expectations move markets.
It’s true this could take a long time to play out. It’s also true, however, that markets factor anticipated futures into present-day asset prices. Therefore, the question to ask isn’t “when will instability get bad, if it does get bad?” but rather “when will it become market consensus that the U.S. business climate may be impaired in the future?” The latter yields a shorter timeline than the former.
The three principles above represent a “don’t predict, prepare” approach, which is the right posture in situations where we know something is coming but can’t predict exactly what or when it will occur. What we know today is key structural underpinnings of the historically stable and prosperous postwar period in America have shifted, giving way to a more volatile, uncertain era.
This is a different investing environment than anyone alive today has ever had to navigate. Good models don’t exist and financial strategies, including this one, are untested. We should all proceed accordingly.
Notes:
https://www.brookings.edu/research/is-democracy-failing-and-putting-our-economic-system-at-risk/#footref-36
https://www.theatlantic.com/magazine/archive/2022/01/january-6-insurrection-trump-coup-2024-election/620843/
https://www.northerntrust.com/japan/insights-research/2022/investment-management/home-country-bias
Obviously, if Trump wins outright he wouldn’t need to use this election-stealing infrastructure.
U.S. debt was downgraded by Standard & Poor’s in 2011 after Republicans led by Ted Cruz used the threat of debt ceiling default to try to force President Obama to make policy concessions.
As lots of people do, a phenomenon called home country investment bias.