Markets cannot afford to view politics and political risk through rose-tinted glasses
That the worst-case scenarios – a Le Pen presidency in France, a market crash following Trump’s victory and a sharp, Europe-wide sell-off in the wake of the Brexit vote – have been averted does not mean political risks have dissipated. Far from it
One of the most talked about themes in financial markets this year has been the willingness of international investors to shrug off the plethora of vulnerabilities that threaten to undermine sentiment.
One of these is the likelihood of a political shock in a major developed or emerging economy that could lead to a significant shift in government policy.
After last year’s dramatic developments – the unexpected decision by Britain to vote to leave the European Union and the upset victory of Donald Trump in the US presidential election – political risk is being taken more seriously by traders and investors.
Yet while political threats may figure more prominently in the list of concerns of fund managers, there are scant signs that investors are overly concerned – indeed quite the opposite.
Not only do most market participants play down political risk, they increasingly perceive political developments as a reason to remain bullish on the outlook for markets and the global economy.
This is partly due to the better-than-expected outcomes of a number of closely watched elections in both developed and developing economies.
The most recent example of this was the election on Monday of Cyril Ramaphosa as leader of South Africa’s ruling African National Congress.
Ramaphosa, who campaigned on a pledge to stamp out graft and reform South Africa’s ailing economy, narrowly defeated the former wife of the country’s corruption-tainted president, Jacob Zuma, who favoured populist policies.
With Ramaphosa now in poll position to succeed Zuma as president, investors have become more optimistic about South Africa, causing the rand, the country’s currency, to rise 4 per cent versus the dollar on Monday, bringing its gains over the past month to a staggering 11 per cent.
Investors are also optimistic about reforms in several emerging markets. In India, premier Narendra Modi, who won a crucial election in his home state of Gujarat last weekend, has carried out far-reaching economic and banking reforms which, although marred by poor implementation, contributed to last month’s first sovereign credit rating upgrade in 14 years.
Indian equities have surged 33 per cent in dollar terms this year while nearly 90 per cent of the country’s electorate holds a positive view of Modi.
Yet it is in Europe and the United States where investors have been the most inclined to see the political glass as half full.
The pro-European and reform-minded Emmanuel Macron’s victory over the nationalist Marine Le Pen in France’s high-stakes presidential election in May has helped turn around sentiment towards the entire euro zone, convincing investors that Europe has been spared the anti-establishment backlash in Britain and the US.
The euro is up 11 per cent against the dollar since mid-April, buoyed by a surprisingly brisk economic expansion.
In the US, markets have turned a blind eye to the Russia scandal engulfing the Trump administration and have instead focused on the passage of a long-awaited US$1.5 trillion tax-cutting package which, having been approved by the Senate on Wednesday, is expected to be signed by Trump in the coming days. The president has also presided over a collapse in volatility, with the US equity market enjoying its calmest year since the mid-1960s.
Yet just because the worst-case scenarios – a Le Pen presidency in France, a market crash following Trump’s victory and a much sharper and Europe-wide sell-off in the wake of the “Brexit” vote – have been averted does not mean political risks have dissipated. Far from it.
The fact that even the twin shocks of Brexit and the election of a demagogue as US president – two developments which early last year were almost unthinkable and which most investors believed would have sent markets into a tailspin – have failed to dent risk appetite speaks volumes about the current state of markets.
Years of ultra-loose monetary policy, coupled with the desperate search for higher-yielding assets, have significantly increased investors’ tolerance of political risk – so much so that it is doubtful whether any political shock could precipitate a financial crisis.
It would have to be one which was part of a broader economic and banking crisis and, crucially, was perceived by investors to pose a systemic threat to the global economy.
The country which has long ticked all these boxes is Italy, Europe’s third-largest economy, which is holding a crucial parliamentary election in March in which populist parties are expected to perform well.
Still, with the European Central Bank in no rush to end its asset purchases, the betting is that investors will continue to view political developments through rose-tinted glasses.
Nicholas Spiro is a partner at Lauressa Advisory