A new phenomenon is filling the vacuum left by the fading influence of central banks

The UK Brexit vote heralds the rise of political risk in setting investor perceptions towards markets and risk

PUBLISHED : Thursday, 04 August, 2016, 2:32pm
UPDATED : Thursday, 04 August, 2016, 10:44pm

On Wednesday, a survey by IHS Markit, the financial data provider, showed that output in Britain’s services industry - which accounts for nearly 80 per cent of the country’s economy - last month suffered its sharpest fall since March 2009, increasing “the chances of the UK sliding into at least a mild recession”, the report noted.

...domestic political developments are influencing international economic and market conditions to a much a greater extent

Coming on the heels of Monday’s publication of a separate survey showing that manufacturing activity in Britain shrank at its fastest pace in nearly four years, the bleak data on services sector output is the latest sign that economic growth in Britain - which was still holding up relatively well in the second quarter of this year - appears to have gone into reverse since the UK’s shock decision on June 23 to vote to leave the European Union (EU).

The sudden post-referendum deterioration in Britain’s economy is also the clearest example of how domestic political developments are influencing international economic and market conditions to a much a greater extent than was the case over the past several years.

Up until mid-2015 or so, central banks’ ultra-loose monetary policies were desensitising investors and traders to all sorts of country-specific risks.

But over the past year, and particularly since the beginning of 2016, the credibility and efficacy of these policies have been called into question, undermining central banks’ ability to stabilise markets and turning the world’s main monetary guardians (in particular the US Federal Reserve) into a major source of volatility.

The UK vote to exit the EU is a Rubicon-crossing moment in investor perceptions of political risk.

Not only has it occurred at a time when markets are losing confidence in central banks, it is having a detrimental impact on both investor sentiment and, more worryingly, economic activity.

Yet the Brexit vote is not the only example of domestic politics exerting a strong influence on markets and economies.

While investor concerns about China have diminished significantly since the beginning of this year, Beijing’s frantic efforts to stabilise China’s equity and currency markets in the second-half of last year exposed the authorities’ instinctive distrust of (and indeed downright antipathy towards) market forces. This has undermined the credibility of China’s policy regime and thrown the tensions between political control and financial reforms into sharp relief.

Although China’s central bank pledged in August 2015 that it would make the renminbi’s value more market-driven as part of broader efforts to liberalise the world’s second-largest economy, the yuan’s daily exchange rate is now back under tight control, according to meeting minutes of private deliberations at the People’s Bank of China obtained by the Wall Street Journal. President Xi Jinping, who has taken charge of China’s economic policy, has described China’s financial markets as “immature”.

Domestic political considerations are also at the heart of efforts to shore up Italy’s creaking banking sector.

Matteo Renzi, Italy’s premier, has just engineered a private rescue of Monte dei Paschi di Siena (MPS), the country’s third-largest bank and the focal point of investor anxiety about Italy’s ailing banking sector, in order to avoid imposing losses on hundreds of thousands of Italian families who own some of the bank’s bonds. Yet the rescue of MPS is shifting attention to other Italian banks which may need to raise more capital to address their worryingly large pile of bad loans.

It is US politics, however, which threatens to have the biggest impact on sentiment and economic conditions.

If Donald Trump, the anti-establishment Republican presidential candidate, wins November’s election, he could become a dangerous American version of Silvio Berlusconi, Italy’s populist ex-premier whose former career as a famous businessman proved to be a liability during his two terms in office, with slogans and promises of change substituting for credible and sensible economic reforms.

HSBC warns of a scenario in which Trump wins the presidency and the Republican party maintains control of both houses of Congress. Under this scenario, which it dubs a “populist overhaul,” there would be a “spike in economic policy uncertainty”, a sharp rise in inflation to 4-5 per cent, a weaker dollar that could fuel global “currency wars” and a decidedly “risk-off” environment in markets.

Fortunately, domestic politics is also leading to positive developments, such as structural reforms in several major emerging markets (notably Argentina and Indonesia) and, crucially, a fiscal stimulus plan in Japan which at least reduces the economy’s dependence on ultra-loose monetary policy.

For now, however, “Brexit risk” and “Trump risk” dominate the headlines.

Nicholas Spiro is a partner with Lauressa Advisory