(FT) Rational markets expect crazy economies

(FT) The financial crisis showed limits of models. Fiscal and monetary policy are even less predictable.


With global asset prices embarking on another alarming rollercoaster ride this week, some investors feel it is time to throw in the towel. In London, one leading hedge fund has done just that.

On Monday, Nevsky Capital, a respected emerging markets specialist launched almost two decades ago, told its investors that it is shutting up shop.

The reason? Martin Taylor, Nevsky’s co-founder, thinks the world economy is subject to so much political risk that “it is more difficult than ever before for us to accurately forecast macroeconomic and corporate variables”.

One of Mr Taylor’s main concerns, according to an investor letter reprinted on the Zero Hedge website, is the fact that events in China and India are increasingly shaping the global economy. The trouble is that it is difficult to know just how they are shaping it. “Obfuscation and distortion” make official numbers on the state of their economies unreliable.

But political risk is key. Though Nevksy sprang to life in the post-Soviet era, and found early success analysing the actions of a capricious Russian government, it has spent the past two decades thinking the world was shaped by the “logical joy of the Washington Consensus”. Now, it fears this consensus — founded on faith in free markets — is breaking down.

“Never has so much of the world been governed by leaders where the logic of that peculiarly parochial yet multi-headed beast — nationalism — trumps all,” Mr Taylor writes. This, he says, is “leading to highly unpredictable and potentially dysfunctional modelling outcomes”.

Some readers will roll their eyes. After all, savvy investors often love political risk; as Nathan Mayer Rothschild is reputed to have said of the Napoleonic wars, the biggest profits are often made when “there is blood in the streets”. Hearing a fund manager wailing about “uncertainty” is thus a bit like hearing a politician or chief executive saying they are resigning to “spend more time with the family”.

Nevertheless, Nevsky’s letter is highly symbolic — particularly in a week when the oil price is tumbling, the Chinese markets have crashed and currencies are swinging wildly.

After all, Nevsky is not acting out of obvious desperation. On the contrary, it has produced annual average returns of 18 per cent since inception — far better than most rivals. In addition, while it posted gains of only 0.4 per cent last year, that looks almost dazzling compared to performance of the MSCI emerging markets index or overall hedge fund index, which lost 14 per cent and 3 per cent respectively.

Moreover, it is not alone in drawing in its horns: several high-profile funds, including BlueCrest, Seneca, LionEye and Lucidus Capital have recently done likewise. They have all presented their decision in slightly different ways but all point to a common theme: markets are becoming so unpredictable that tried and tested strategies are breaking down.

This highlights a bigger point: Mr Taylor is merely articulating in an unusually forceful manner the fears that other asset managers harbour.

A decade ago, it was taken for granted by most western investors that economies could be analysed with “rational” models. The financial crisis of 2008 showed the limits of this approach. Waves of capricious government intervention that have taken place since have offered a second lesson in unpredictability.

But now a range of political shocks — such as the intensifying tensions between Saudi Arabia and Iran — are showing the folly of using economics alone to forecast where economies are headed. A century ago this point was well understood: as Niall Ferguson, the Harvard historian, has pointed out, military conflict was so endemic in the 19th and early-20th century that nobody would have dared think money and markets (or even central banks) could be separated from politics.

But this was often forgotten in the latter years of the 20th century, when events seemed relatively predictable. A world shaped by irrational politics and capricious policies — in the west as well as in China and other emerging markets — is not something modern investors are equipped to deal with.

Of course, if you want to be optimistic, it is possible to argue that this is just a short-term phenomenon. Mr Taylor insists he still believes that, since “the laws of economics will never be repealed”, his rational, model-based approach will “eventually” become relevant once more.

Just do not count on this happening soon.Rational-markets-expect-crazy-economies-FT