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Cuba and Trump: a quick study in market blindness

For a quick study in market blindness, look at how an obscure US fund reacts to events in a country where markets do not even exist.

Nearly two years ago US president Barack Obama and Cuban president Raúl Castro jointly announced their intent to rejuvenate the diplomatic and commercial relationship between their two countries. Until that day, the Cuba closed-end fund had historically traded beneath its net asset value by roughly 10-15 per cent. This Nasdaq-traded fund invests in American companies whose shares are expected to benefit from cosier relations between the US and Cuba.

A closed-end fund selling at a discount for prolonged stretches of time is itself a mysterious phenomenon. But it is also common. What happened next was decidedly uncommon. The day after the joint announcement, the Cuba fund more than doubled in price despite no such move by the shares of the companies it held. Eventually, it reached a price that was 70 per cent higher than the aggregate value of its holdings. Only gradually did some investors realise that their initial optimism about the implications of the announcement for their fund was premature. Almost a year passed before the fund had fully crossed its net asset value and again traded at a discount.

The Cuba fund has experienced another two ephemeral spikes in price since then: last February ahead of Mr Obama’s historic visit to Cuba, and two weeks ago after the death of Fidel Castro. In each case new buyers might have believed that the specific event would lead to faster improvements in economic fundamentals, but more likely they were just participating in a typical Keynesian beauty contest, buying on the expectation that others would buy.

Leaving aside Trump’s erratic nature, US politics is about to enter a period of densely intricate horse-trading whose results are entirely undetermined

No wonder that behavioural economist Dick Thaler often cites the fund as an example of the efficient market hypothesis breaking down. Curiously enough, several timely and relevant lessons can still be taken from the fund’s idiosyncratic recent history.

One lesson is that investors should be cautious about jumping into a trade that is predicated on a political event turning out the way markets expect. The most prominent example at the moment is obviously the “Trump trade”, premised on Donald Trump and Congressional Republicans successfully agreeing a fiscal deal that includes infrastructure spending, tax cuts, and financial deregulation.

Leaving aside Trump’s erratic nature, US politics is about to enter a period of densely intricate horse-trading whose results are entirely undetermined. The simple truth — and the second lesson — is that markets will always reflect better than they predict, even as they are always attempting both.

Consider all that has happened in 2016. The frightening turbulence in China that started the year subsided after the government injected further stimulus. Brexit was not an immediate economic catastrophe. The eurozone grew modestly but steadily, while the US and Japan shrugged off a disappointing first half to record a strong third quarter. US wage growth and price inflation finally started accelerating. Abysmal recessions in Russia and Brazil seem to have bottomed. Oil and other commodities rebounded. Leading indicators of global economic activity are in fine health.

Despite plenty of extant risks, the avoidance of the doom scenarios expected at the end of last year thus makes the reflation of markets unsurprising in hindsight. They are merely keeping up with big structural shifts.

It is important to keep the Trump trade in perspective. Gains in equities, the US dollar, inflation expectations, and long yields may have advanced in response to the US election, but all of them started as early as mid-2016. Whether they have raced ahead of fundamentals simply remains unclear for now.

Aside from endless Trump hysteria, next year also brings more threats to the stability of Europe with elections in Germany and France, while the fates of Italian banks and politics also remain foggy. Lesson number three is that with omnipresent political risk entrenched in both developing and advanced economies, more sharp swings will be impossible to avoid.

Also worth mentioning is that each subsequent shortlived spike in the Cuba fund’s prices has peaked lower than the one before it, and each correction quicker. Investors sometimes do learn from mistakes, as well they should — a fourth and final lesson.

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