Investor Sentiment Benefits U.S.May 2, 2014
Fear surrounding government intervention in the market economy can decrease investor confidence and affect a decision maker’s willingness to allocate capital in a country. In the global economy, investors have the option to deploy capital in many foreign markets. They will be hesitant to do so if they feel there is an insufficient governing structure to promote public confidence in the market and preserve the rights of property owners. Investors’ country-specific concerns can cause them to shy away from companies or projects that look attractive from a business fundamentals standpoint. This reaction is the case in Russia which has seen huge capital outflows due to their decision to take over Ukraine’s Crimea region. Data released by the Russian central bank shows that capital outflows from 2013 totaled $63 billion. The Wall Street Journal reported on April 16, 2014, that net capital outflows exceeded $60 billion in just the first quarter of 2014.
Russia is the most recent example of large capital outflows due to country-specific risk but investors are constantly monitoring sociopolitical issues to determine the best way to allocate their portfolios. In the international and global asset classes, managers measure country-specific risk to determine the appropriate discount rate for capital investments in a region. Jerome Gratry has been managing international and global strategies with Gratry & Company since 1981 and provides model portfolios approved by FDx Advisors. Mr. Gratry and his team have refrained from making direct investments in Russian companies in the International and Global portfolios due to their perceived instability of the government there. At times, the portfolio team at Gratry & Co. was bullish on the materials sector, which makes up much of the Russian economy, but their top-down analysis of the region kept them from investing capital there. In a similar example where top-down factors drove the investment decision, Mr. Gratry chose to pull out of their position in Petrobras due to fears that the Brazilian government would continually metal in the affairs of the company by fixing prices in the energy sector.
In many cases, the relative attractiveness of a country from an investor’s perspective comes down to the government’s willingness and ability to protect the virtues of the free market. An investor is incentivized to purchase equity in a company by the hopes of sharing in the future earnings of the business. A free market allows companies to deploy their human and physical capital to the highest valued user which leads to the best chance of earning an accounting profit. In Russia and Brazil, we have seen both countries negatively impacted by the perception that businesses will not have access to free trade, thus limiting the avenues for capturing value from their goods and services. The iShares MSCI Russia Capped Index (ERUS) currently trades at a 5 P/E which is over three times cheaper than the iShares Russell 1000 (IWB) which trades at a 17 P/E. The willingness for investors to pay much less for Russian earnings signals that market participants currently require a much higher return on equity and/or have lower earnings growth expectations in the Russian economy.
The U.S. currently benefits from a relatively cheap cost of equity financing because companies are able to fund projects that would not be feasible if investors required a higher return on their investment. Many of these marginal projects create jobs and may ultimately lead to innovative products that have a multiplier effect on economic growth. The relatively low cost of equity financing in the U.S. is reflective of investors’ sentiment and represents a belief that the political system is willing and capable of protecting the virtues of the free market. Investors believe that U.S. companies will be allowed to earn a profit in the market and their right to share in the profit will be upheld by the U.S. regulatory body. If the U.S. is going to keep this advantageous cost of capital which propels economic growth, the country will need to continually prove to investors that the government will protect their interests.
During the financial crisis, many economists pointed out the potential pitfalls of the U.S. government’s intervention in the free market to prop up failing institutions. The aftermath of the decision to intervene in the market is creating some scrutiny around the Treasury’s exit from their General Motors holding. The rational for the scrutiny surrounding the GM exit is that government agencies have access to material nonpublic information and influence on policy decisions which can ultimately shape the performance of their investments. The dueling interests regarding the preservation of government invested capital and the government’s regulatory duties is enough to create uncertainty in the mind of investors. Market pundits are drawing attention to the potential “double standard” regarding the Treasury’s sale of the GM stake because the Treasury may have been in possession of material nonpublic information regarding a planned vehicle recall. This scenario would normally trigger an insider trading investigation in the private market. The government’s moral dilemma creates uncertainty in the objectivity of our regulatory bodies, which, if left unchecked, could ultimately lead to a capital exodus. The threat of too much government involvement can scare away potential investors as was the case with Gratry & Company’s investment in the Brazilian energy company, Petrobras.
Many of the actions taken during the financial crisis created a market environment which undermines the most important ingredient for a thriving economy: trust. They say that trust is the most expensive thing in the world because it can take a lifetime to earn and only seconds to lose. To hold the trust and confidence of global investors, the U.S. must continually prove that the system is capable of protecting their interests. In order to maintain the benefit of low cost financing driven by investor sentiment, the U.S. needs to reassure global markets of the objectivity of the regulatory bodies and show commitment to the guiding principal that the government will not continually intervene in the private market.