Politics emerges as key determinant of market sentiment
Investors losing confidence in ability of central banks to stabilise markets in times of financial turmoil
On Monday, the Russian rouble fell more than 3 per cent against the US dollar in early trade. Later in the day, Brazil’s central bank had to intervene to weaken the real, the country’s currency, which has strengthened 11 per cent against the US dollar since the end of February. Then, Argentina ended a 15-year exile from the international debt markets by selling US$16.5 billion of government bonds that attracted bids of more than US$65 billion.
These three developments have one thing in common: the importance of political factors in determining market conditions.
The rouble’s initial decline was part of a broad-based sell-off in commodity-linked currencies stemming from the failure of the world’s major oil producers to agree on a deal to freeze output because of Saudi Arabia’s refusal to back an agreement without the participation of Iran, its regional rival which is emerging from years of Western sanctions and is ramping up production.
While the rouble quickly bounced back as oil prices recovered, benefiting from traders’ focus on the gradual rebalancing of the market, the politicisation of Saudi Arabian oil policy shows the extent to which political and geopolitical factors have a strong bearing on investor sentiment.
In the case of Brazil’s currency – and Brazilian assets in general – they have become a political trade as investors take comfort from the increasing likelihood that Dilma Rousseff, Brazil’s deeply unpopular president, will be ousted following the decision on Sunday by the lower house of the country’s parliament to open impeachment proceedings against her.
Meanwhile, in Argentina, the election of a market-friendly president, Mauricio Macri, in November following a long period in which Latin America’s third-largest economy was an international pariah and financial basket case has buoyed sentiment, with one institutional investor describing Macri’s economic policy team as “one of the best in emerging markets”.
One of the reasons why investors are being forced to pay more attention to political developments is because of diminishing confidence in the ability of central banks to stabilise markets during periods of financial turmoil.
Having long desensitised investors to all sorts of country-specific risks, central banks’ ultra-loose monetary policies are now backfiring – the most conspicuous example of this is the fierce backlash against negative interest rates in Japan and the euro zone – and amplifying vulnerabilities and stresses in the global economy.
Indeed according to the latest Global Fund Manager Survey published by Bank of America Merrill Lynch, the failure of central banks’ quantitative easing (QE) programmes is now the biggest “tail risk”, according to the 200 or so institutional investors who participated in the survey.
In its latest World Economic Outlook published last week, the International Monetary Fund warned that “non-economic factors, including geopolitical tensions and political discord” are “generating substantial uncertainty” in the outlook for the global economy.
Another reason why investors have become more sensitive to political developments is because of increasing differentiation between economies – particularly in emerging markets (EMs) where countries differ significantly in terms of economic performance and financial vulnerability.
Higher-yielding EM assets in countries with relatively strong fundamentals or, in the case of Argentina (and possibly Brazil if Rousseff is forced to step down) compelling “reform stories”, are in strong demand, especially at a time when yields on the bonds of advanced economies are at ridiculously low levels and sentiment towards EMs continues to improve.
Still, political risks continue to be underestimated and underpriced in many countries.
In Spain, which has been without a proper government since an inconclusive election in December and is heading for a repeat election in June, the yield on the country’s 10-year bonds currently stands at just 1.5 per cent – even lower than just before December’s election. Indeed Spanish 2-year yields are in negative territory.
There is arguably an even greater mispricing of risk in Italy – the country’s 10-year yield stands at just 1.4 per cent – where banks’ balance sheets are crippled by very high levels of non-performing loans stemming from a protracted economic downturn.
Yet at least investors are taking the biggest political risk – the threat of a British exit from the European Union (Brexit) in a referendum on June 23 – extremely seriously.
The pound has fallen a further 3 per cent against the US dollar this year – bringing its losses against the greenback since mid-2015 to nearly 10 per cent – because of concerns about the fallout from a possible Brexit.
While Britain is likely to vote to remain in the EU, Brexit risk will be a focal point of market anxiety in the coming weeks, another indication of the extent to which politics is shaping sentiment.
Nicholas Spiro is a partner at Lauressa Advisory