Two distinct camps are emerging in the markets: one emphasising the uncertain political outlook and the other downplaying the political impact on the wider economy. Paras Anand, CIO Equities, Europe, argues that the heightened sense of a political ‘black swan’ event is overshadowing the important trends of a reduction in systemic risk since the Global Financial Crisis and the relentless onward march of technology.
Two political camps
When it comes to thinking about how the uncertain political environment will shape markets, two distinct camps are emerging. One side believes the shifting political landscape will have consequences for the global economy, currencies and asset prices that will dwarf all other considerations. The other side believes that politics is a distracting backdrop which will only have negligible effects.
Currently, the latter camp appears to be two-nil up in the game following the hard-charging markets in the aftermath of Brexit and the US election. I suggest that neither group is entirely right and perhaps investors should be watching a different match altogether.
Are we worrying too much about politics?
A case can be made that the powerful combination of non-stop news coverage and a genuine shift from ideology-based to national identity politics has led to outcomes previously thought remote. These events have been widely painted as both significant and unusually influential for economic growth and the financial markets.
Those in the 'distracting backdrop' camp, on the other hand, justify their view by citing the resilience of the economy, robust equity markets, checks and balances on disruptive government policy and that the wheels of politics are slow to turn.
While those factors are generally true, there remains the real threat of complacency. The first camp will also point out that while equity markets were surprisingly robust in the face of Brexit and the Trump election victories, sterling and bond markets were not, so it would be incorrect to say there were no financial market impacts of last year's events.
Additionally, they highlight that the extremely cautious market sentiment at the outset of 2016 when there were genuine fears of a global recession, conditioned markets to accept Brexit and Trump with a relative degree of equanimity. This response has generated a false sense of security towards future shocks. In other words, they would argue that base level expectations have changed, setting up markets for a rude awakening if and when a political shock does strike.
As undecided market participants determine which of the above camps to join ahead of the upcoming high-stakes European elections, I would draw investors' attention to two factors that are being overlooked amid the political domination of the headlines: the reduction of systemic risk and technological progress.
Reduction in systemic risk
The market is yet to fully accept that the risk of systemic shock has reduced significantly since the Global Financial Crisis.
It could be argued that there have been three major systemic risks since the GFC;
- Political contagion - specifically the spread of populism
- Sentiment contagion - mainly the belief in stagnation
- Economic contagion - the scope for a crisis in one economy to lead to demand destruction in others
Of the three, the market has rightly been most concerned with economic contagion and this largely explains why top-down analysis has taken centre stage in recent years.
Real economic contagion spreads through the financial system by attacking points of vulnerability where the system is highly leveraged and tightly interconnected. Over the past eight years, aggregate leverage and interconnections have declined, which ought to have put politics and macroeconomic events into more perspective.
There are many negative outcomes that investors fear, but constantly labelling events as black swans gives those outcomes an unwarranted status. For example, in the potential event of Greece leaving the single currency in 2017 or 2018, it would be just as significant as if it happened in 2012, but crucially far less consequential for markets given the recovery in the European economy since then.
Technological progress
Whatever is happening in the wider political debate; technological development is both rapid and borderless and will have a greater impact on consumer tastes, wealth creation and corporate success and failure than the vast majority of government policy.
It is notable that despite explicit rhetoric from the US government to shore up old economy sectors, the Nasdaq continues to post impressive returns. Given this market signal, perhaps investors’ most critical task over the coming years is to analyse to what extent technology will shift the corporate landscape, disrupt established value chains and/or open up new opportunities for leading franchises.
Conclusion
The good news is that while the political environment continues to enthral most market participants, there is the scope for politically-driven sentiment swings that can provide good long term investment opportunities.
