Why trust matters for investors - Angles & Perspectives Q2 2024

Why trust matters for investors

Economies and financial markets are built on a foundation of trust. Without it, markets become inefficient and governments lose credibility. Poor or short-sighted fiscal and monetary policies or consistently missing economic targets is typical of ‘untrustworthy’ governments, and it can create a low-trust environment with huge potential implications for investors.

Nowhere is this more pertinent than for fixed income investors, as purchasing a country’s sovereign bonds requires a leap of faith that the yield available will compensate you for the risks taken for many years into the future.

Historically, low-trust countries were typified by emerging markets (EMs) with unsustainable debt burdens, large twin deficits, a high dependence on foreign flows, questionable rule of law and polarised politics. But today, that characterisation can be applied to several developed markets.

The decline in US economic fundamentals and the fact that policymakers’ intentions may be at odds with the interests of bond holders, make us question the role of developed market sovereign bonds as a benchmark financial asset and portfolio safe haven.

It all starts with trust

Oxford University lecturer and author Rachel Botsman has spent many years researching trust. Trust is highly subjective and contextual. In a recent presentation, she makes the point that when deciding whether to trust someone, we need to pair it with ‘to do what?’ to provide necessary context.

There is proven science around what makes someone trustworthy, as described by her trust equation. It has four components: competence, reliability, integrity and empathy. Of these, integrity is considered the most important.

Botsman describes trust as ‘a bridge between the known and unknown’ and as such, trust is an essential yet a largely ignored aspect of an economy and especially financial markets. What do high or low levels of trust mean for markets, and why should investors care about changes in levels of trust over time?

Low levels of trust correlate with high inflation

If we ask the question “Do you trust the government’s economic policy?” we can instinctively see the link between trust and financial markets. It is well understood that inflation expectations help to shape actual inflation outcomes.

A low-trust environment has huge potential implications for investors, as poor or short-sighted fiscal and monetary policies or consistently missing economic targets may lead to high levels of macroeconomic volatility.

The OECD Trust Rating Survey asks: “In this country, do you have confidence in the national government?” Their most recent poll covered 41 countries.

Our analysis shows that in the most recent 2022/23 inflation cycle, the 10 countries with the lowest government trust scores (35% or lower) had an average inflation peak at 15.9% while in the 10 countries with the highest trust scores (60% or higher) inflation peaked at 9.1%.

Lower trust means higher macro risk?

Low levels of trust in the government does not cause inflation (correlation is not causation). We think the causes of inflation are complex and multi-faceted, as laid out in our Q2 2023 article ‘Arthur Burns, William Miller and learning the right lessons from history’.

However, we would make the case that low levels of trust, or a significant decline in trust, raises the vulnerability to inflationary events and increases the risk that bouts of macroeconomic volatility may be exacerbated or prolonged by second-round impacts.

Given this, the impact of a low level of trust in a specific economy may not be directly felt for years, but rather represents a vulnerability that could reduce economic and political resilience during periods of upheaval.

The US is now a low-trust society

If we compare two developed countries at opposite ends of the trust scale, the US and Switzerland, we see a dramatic difference in their recently recorded levels of the consumer price index (CPI). While we think inflation always has many causes and accelerators, this is still an interesting divergence between two wealthy developed countries.

The new emerging markets

In the post-Covid world, many developed markets (most notably the US) now align to descriptions previously reserved for low-trust EM countries: having unsustainable debt burdens, large twin deficits, questionable rule of law and polarised societies.

Eighty years ago, more than 70% of Americans said, “We trust the government to do what is right just about always or most of the time.” This has dropped to just over 20% today. (Pew Research Center).

The decline in US economic fundamentals (wide budget deficits set to continue with demographic pressure from the retiring Boomers, government debt-to-GDP ratio at a post-WW2 high and forecast to get much worse, consistent current account deficits and hence reliance on continued foreign flows) has accelerated since 2009, and now actually looks typical of an emerging market in the ‘bad old days’.

We also note that since 2009, the trust rating has remained at lows of around 20%.

The trust equation raises questions

Purchasing a country’s sovereign bonds requires a high level of trust that the available yield will compensate you for the risks taken. We question whether the current yields on US treasuries provide adequate compensation for that leap of faith.

Given the very high and worsening debt levels and the associated policy constraints, US policy has been inconsistent and there is a high probability that the US will not be able to deliver on the implicit promises its bond holders rely on - i.e. they may not be ‘competent’ in terms of the trust equation above).

More importantly, US policymakers’ intentions may be at odds with the interests of bond holders, calling into question their integrity (negative real yields will help reduce future levels of debt to GDP, but are catastrophic for bond holder returns. This makes us question the role of developed market sovereign bonds as a benchmark financial asset and portfolio safe haven.

Beware the tail event

Most of today’s investors were grounded in the 60/40 portfolio that performed well through the benign secular stagnation environment of the 2010s, which was also the last decade of a 40-year declining interest rate cycle. We believe that this period is likely to offer poor preparation for what lies ahead.

To navigate a low-trust environment you need an awareness of the risk of severe ‘tail events’ (so called because they are on the edge of a distribution of possible outcomes) and how they would impact portfolios.

These events are nowhere to be found in the typical lookback periods of the quantitative risk models used almost universally by the asset management industry. Resilient portfolio construction requires not just data, but also the creativity to imagine a different world.

Operating in a world of broken trust

What happens when a government breaches the trust of investors? We had a preview of that in 2022 with the collapse in developed market bond prices. However, the non-linearity and violence of investors’ reactions to a loss of trust have been displayed many times in history.

Perhaps the best primer for this and for understanding monetary policy in general, is the book ‘Lords of Finance: The Bankers Who Broke the World’, which outlines the events leading up to and culminating in the Great Depression:

"…experimenting with the currency was like walking a knife edge. A moderate degree of inflation does not remain moderate for long. At some point the public loses confidence in the authority’s power to maintain the value of money, and deserts the currency in panic."

We believe the US’s declining economic fundamentals make it significantly less trustworthy than in the past, and less trustworthy than other nations historically regarded as higher risk.

Ironically, the exposure of global investors to US assets has never been greater. Long-duration US bonds in particular demand a high level of trust not supported by our work, and should be avoided at current yields.

References

Rachel Botsman, The currency of trust, DLD 19 Conference, https://www.youtube.com/watch?v=-vbPXbm8eTw
Pew Research Center, Public Trust in Government: 1958-2024, https://www.pewresearch.org/politics/2024/06/24/public-trust-in-government-1958-2024/
Liaquat Ahamed, ‘Lords of Finance: The Bankers Who Broke the World’.