October 4, 2013 5:09 pm
Debt Armageddon puts game theory to test
During the Cold War, when the world feared nuclear annihiliation, scientists developed “game theories” to predict possible scenarios – and the chances of reason prevailing.
This week investment strategists have applied similar thinking to the US fiscal crisis: the political deadlock in Washington over the federal budget and the debt ceiling that, at least in theory, could plunge the world into the Armageddon of a US debt default.
World and US equities, US government bonds and US dollar
ON THIS STORY
- Gavyn Davies US default by any other name
- John Kay the basics of negotiation
- Gary Marcus Math and science
- FT series Sequestration Nation
- ‘Stable allocations’ theory wins Nobel prize
ON THIS TOPIC
- Investors follow usual US shutdown script
- Shutdown puts trade talks on ice
- Lockheed to send 3,000 workers home
- Bargain or fudge ways to end deadlock
IN EQUITIES
Markets are still confident it will be apocalypse averted. By yesterday lunchtime in New York, the S&P 500 was broadly unchanged over the week, and the FTSE All World index down just 0.5 per cent.
But the mood was queasy. Yields on one-month US Treasury bills, a gauge of near-future worries, hit the highest levels since February 2009 and the dollar has weakened.
The risk is that rudimentary calculations prove wrong – and that negative scenarios are being underpriced.
“The conventional view, based on game theory, is that you don’t want to sell only to have to buy back later at higher prices,” says Bill McQuaker, head of multi asset at Henderson Global Investors. “There is a degree of sense in that – but it is not hard-wired into the system.”
Stephen King, HSBC’s chief economist, tweeted from Washington: “All sorts of game theory stuff going on in DC . . . Time to brush off theories of mutually assured destruction . . .”
The market calm assumes politicians will eventually pull back from the brink because of the incalculable but almost certainly catastrophic consequences of a default.
The US Treasury has warned credit markets could freeze, the dollar plummet and interest rates skyrocket.
Traditional game theory – widely used in academic economics – allow for amicable outcomes, especially when participants learn from experience.
But it may be incapable of predicting just what will happen in situations as intricate as the stand-off in Washington, where investors have to make sense of convoluted political processes and actors with different aims, ambitions and hobby horses – and that is just the Republicans.
“Game theory is good when you have two players in a stable situation, like the Cold War,” says Neil Johnson, physics professor at Miami University, who has applied such mathematical concepts to finance.
“In this situation, it’s hard even to tell how many players there are and who they are – or what the pay-offs would be.”
His studies of complex situations of “dynamic elasticity” tell him that investors should “expect the unexpected” in the US fiscal crisis.
“In simulations, there is almost a calm before the storm. As actors lock into their positions the situation looks stable – but then suddenly it veers off.”
Quite where that would take financial markets, he admits, is not yet clear. “That’s the difficult bit.”
Even without complex, multi-dimensional analysis, however, games theory warns irrational behaviour can result in disruptive outcomes.
Many strategists believe a sharp financial market significant sell-off and the threat of significant disruption to the real economy may be needed before politicians are forced into a deal.
Barack Obama, US president, has warned that Wall Street should be worried. “When you have a situation in which a faction is willing to default on US obligations, then we are in trouble,” he told CNBC.
Aaron Balsam, of William Blair, a Chicago-based fund manager that uses game theory as part in its strategy, says: “We would be in the camp that ultimately there will be a resolution – but we think it is going to be much more challenging than people expect.”
A sell-off in equity markets could create buying opportunities for investors – assuming a deal was ultimately reached.
A lesson of the eurozone debt crisis over the past few years is that moments of great political intensity are times to jump back into equities to enjoy the subsequent rally. Italy provided another example this week.
A threat last weekend by Silvio Berlusconi, the former premier, to bring down the coalition government of Enrico Letta sent Italian shares falling on Monday but a later U-turn by Mr Berlusconi saw stocks soaring again – the FTSE MIB index ended the week up almost 4 per cent.
“If the politicians leave it to the last minute, there will be investors who panic,” says Trevor Greetham, director of asset allocation at Fidelity. “When politicians panic, it is the time to buy.”
The problem with the US fiscal deadlock will be in getting the timing right. “You could have a flash crash, which would be an opportunity to buy, but a political agreement could come without warning and the market might just keep rising,” warns Mr Greetham.
“The long-term outlook is good. We’re long US equities and not selling ahead of potential volatility.”
Hedge funds and short term investors might be tempted to trade US political developments as they unfold.
For long-term investors, however, it is “essentially untradeable”, concludes Robert Farago, head of asset allocation at Schroders private bank.
“You are 99 per cent sure that ultimately it will be OK, and in the 1 per cent case you don’t know exactly what it means for bonds and currencies. But you do know that equities will take a hit if things go wrong.”
Andrew Goldberg, global market strategist at JPMorgan Asset Management, adds: “If you think there is some game theory by which you can predict what is going to happen step by step and take advantage of the ups and down, that is not going to happen . . . Predicting the illogical path taken by illogical politicians is completely illogical.”
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