At a recent conference in Beaver Creek I met Tim Pawlenty, Republican former Governor of Minnesota and brief candidate for President. At the risk of revealing my political leanings, I was skeptical of what I might be exposed to. I am happy to say that I was pleasantly surprised to hear a conciliatory voice speaking to compromise and common mission. Afterwards I found myself reflecting on how it has become unusual to trust our elected officials to make good decisions, and how important politics has become to investment management. In the investment management field we refer to “political risk” as one type of risk. Political risk is a bit of a catch-all phrase that encompasses many things and often requires a fair amount of context to hone in on the meaning of the term when it is used. Despite the fact that the term covers many potential risks for an investor, it is generally not a type of risk that is regarded as of primary concern. We find ourselves at a point in time when political risk cannot be ignored. My recent thoughts were related to regulatory uncertainty, and the monetary (the Federal Reserve or “Fed”) and fiscal (government) policies in the United States. The twenty years or so prior to the 2008 financial crisis were a long period of incremental deregulation and relaxed monetary policy. Sure, there were counter examples, but for the most part this was a time when government and Wall Street were very chummy and could be relied upon to boost each other. In retrospect, the way this was done leaves much to be desired. However, as an investor, this relationship, as well as other macro-trends in the world, gave rise to a time when the monetary and fiscal political risk in the U.S. was hidden. These risks were invisible due to the economy seemingly working, and the clear intention of politicians and bankers to work for each other’s good. The risks from the permissive relations between government and Wall Street built up in the system, and then came home to roost with the 2008 financial crisis. At that point the Fed and the government became the driving force behind most stock and bond market activity. The private markets faltered and, if they had been left to their own path, would have collapsed – at least for a period of time. To avoid this collapse, the Fed (monetary policy) became a major driving force behind the market through low interest rate policy and purchases of bonds. Put simply, the Fed has been desperately trying to re-inflate the massive loss of value in assets such as stocks and housing in the hope that this will lead to employment and spending. It is trying to do this by making borrowing money cheap. Their hope is that this will also lead to inflation, as it does in more normal times. Inflation is an incentive to spend now rather than wait until later (when things would cost more). Spending is the major driver behind the U.S. economy. The Fed’s success or failure in its goals, and the actions it is taking to achieve them, have a profound effect on the way an investor should invest. In a recession/crisis environment many in government (fiscal policy) would like to lower taxes and increase social welfare programs – actions that lower citizen’s misery and stimulate economic activity. However, our government does not have the means to do these things without taking on massive debt and risking the serious consequences associated with that debt. Government officials have been forced to recognize that decades of inattentiveness to banking activity and growing social service costs have left the country without good options. The U.S. has not saved during good years, and has allowed banks and other financial institutions to become “too big to fail”. This means that increased spending on social welfare and/or tax stimulus has to be paid for entirely by future generations (i.e. borrowed). As well, the public has been forced to assume the finance industry’s debts when those institutions became insolvent. As a result we now have a group of leaders that are torn between raising taxes to pay for deficit spending, lowering taxes to stimulate growth, extending or cutting social welfare programs, increasing regulation, and generally not having a scrap of common direction on what the right thing to do is. The end result, as we see it, is that you must be invested in more than cash and bonds, and you must be diversified. For us as investors, the result of all this is that it is hard to make informed decisions. Market direction and forces are very difficult to predict, but even more difficult to predict are the capricious decisions of politicians. However, it is just these decisions that are now the major driving forces in all markets. At the same time, low interest rates and inflationary monetary policy from the Fed are punishing savers and low risk bond investors – so there’s no such thing as a “risk-free” asset class at this time. The end result, as we see it, is that you must be invested in more than cash and bonds, and you must be diversified. Now is not a time when there is wind in the sails of stocks, or the proverbial rising tide lifting all ships. Which is not to say stocks can be ignored, rather that there has to be more going on. We are ongoing believers in diversifying in many ways. Specifically our portfolios diversify by asset class, geography, strategy, time-frame, and exposure concentration.