Awkward dance between markets and politics set to continue

PUBLISHED : Thursday, 28 September, 2017, 11:03am
UPDATED : Thursday, 28 September, 2017, 10:35pm

It is something of an odd couple. The relationship between global politics and financial markets is an intense one, but at the same time an emotionally distant one.

Signs of the former have been all too evident over the past week.

On Monday, oil prices rose to a two-year high partly because of threats by Turkey’s government to halt vital oil shipments from neighbouring Iraqi Kurdistan as the region pushed ahead with a controversial referendum on independence. The same day, international investors poured money into so-called haven assets as the heated rhetoric between North Korea and the United States intensified.

On Tuesday, the euro fell to its lowest level against the dollar in five weeks after suffering its steepest one-day decline this year the day before in response to the unexpectedly strong showing of the far-right Alternative for Germany (AfD) party in Germany’s parliamentary election last weekend. The AfD’s stunning performance contributed to an 8.5 per cent decline in support for chancellor Angela Merkel’s conservative bloc, leaving it with its lowest share of the vote since 1949.

Bears struggle to be taken seriously as markets remain resilient to risks

Over the past year or so, there have been plenty of other indications of the extent to which political developments affect asset prices.

Britain’s surprise decision in June 2016 to vote to leave the European Union caused the pound to plummet more than 15 per cent against the dollar in the four months following the referendum. Donald Trump’s victory in the US presidential election last November turbocharged a rally in the dollar only for the “Trump trade” to go into reverse as confidence in the scandal-plagued administration’s ability to push through pro-growth reforms quickly evaporated.

In Europe, meanwhile, the victory of the pro-European Emmanuel Macron in France’s presidential election in May has been the key factor behind the more than US$30 billion of inflows into European equity funds this year and is partly responsible for the euro’s 10 per cent appreciation versus the dollar since mid-April.

Make no mistake, politics is a major determinant of asset prices.

Yet the other side to the awkward relationship between politics and markets is just as, if not more, important.

Investors are very poor at assessing and pricing political risk and... often tend to ignore it

While politics clearly influences investor sentiment, investors themselves are very poor at assessing and pricing political risk, and, perhaps for this reason, often tend to ignore it.

One of the clearest examples of this is the market reaction to the dramatic escalation in geopolitical tensions on the Korean peninsula.

Despite the mounting risk of a military conflict, the benchmark S&P 500 equity index is just a few points shy of its all-time high while the Vix index, Wall Street’s “fear gauge” which measures the anticipated volatility in the S&P 500, stands at its lowest level in two decades. Even South Korea’s main equity index is up more than 2 per cent since early September. This is partly because, as JPMorgan notes, “North Korea has generated many false alarms over the past decade”, but also because there is little sense in pricing in, what one analyst aptly calls, an “extinction event”.

Yet even when it comes to assessing political developments in leading advanced economies and their implications for markets, investors are often out of their depth.

Having convinced themselves that populism no longer poses a serious threat to Europe’s economies following Macron’s victory in the French election, markets underestimated the strength of support for the nationalist AfD party in Germany’s election.

Not only did the AfD manage to poach as many as one million voters from Merkel’s ruling conservative bloc, its strong showing – the AfD’s 13 per cent of the vote stemmed almost entirely from the backlash against Merkel’s highly contentious open-door refugee policy which caused over one million asylum seekers to flood into Germany in 2015 – will push German politics to the right. This will make it even less likely that Germany will provide more financial support to shore up the euro zone, increasing the risk of another crisis.

That investors misread Germany’s supposedly “boring” election augurs badly for their assessments of political risk in Italy, an extremely vulnerable country which holds a crucial parliamentary election next year. The combined level of support for populist and nationalist parties in Italy has risen to more than 50 per cent, presaging the formation of a staunchly Eurosceptic government which could be the trigger for renewed financial instability in the euro zone.

Still, as long as central banks’ ultra-loose monetary policies keep bond yields at historically low levels, investors are unlikely to attach too much importance to political developments.

The odd couple could remain odd for some time yet

Nicholas Spiro is a partner at Lauressa Advisory