‘There are no dead ends in democracy’, a popular quote says. The democratic processes in at least 3 G7 countries are certainly grabbing all the attention.
Apart from slightly lower core inflation data in the US, it was a rather quiet week in markets. The investors’ focus was on the French parliamentary election, the US presidential debate and, of course the upcoming UK election.
At the time of writing (Monday morning), Marine Le Pen’s party had turned the tables on Emmanuel Macron and won a large part of the popular vote in the first round. However, market reaction was by and large positive, as pundits now think that a Le Pen government might be a more difficult proposition in the second round. I’d wait for the second round before drawing conclusions, however, as these sort of elections depend on second-round alliances.
In the US, the presidential debate turned into a lucidity and coherence contest between the two candidates. Whoever wins, plenty of Americans feel short-changed by the presidential choices of the two major parties.
And in the UK, anything other than a landslide victory for Labour on the fourth might be considered a surprise by markets.
All that is fascinating. My one political conclusion from these developments, is also an economic one: Governments have been running big fiscal deficits for some time. Eventually, the mainstream governments ran out of fiscal space, which has turned voters to more extreme choices that promise different outcomes. Put it differently, the preference of many voters towards the political extremes means that constituents, desperate for real economic growth, prefer those who promise change rather than the status quo, action over inaction.
However, we don’t think investors should necessarily be afraid.
For one, political extremes are usually short-lived. What used to be the fringes still need to deliver successful outcomes to remain in power. My own experience has taught me that populism, which is nothing more than the promise of a successful change of the status quo, runs in cycles. If the promisors fail to deliver, and they often do because reality checks their extravagant promises, then normality resumes. Voters have vented and mainstream parties have tried to reinvent themselves, so a return to the political centre is the more likely outcome. Politics move fast these days. The easier it becomes to grab power, due to souring political sentiment, the more difficult it becomes to hold on to it for the longer term.
Second, financial markets determine the behaviour of governors. The more debt grows, the more a country is sensitive to bond market oscillations. This was the lesson taught to Ms Truss and Mr Kwarteng. A lesson learned by Italian PM Meloni, as well as Madame Le Pen who quickly toned down her rhetoric at the prospect of true power. To survive, the extremes need to be brought to the mainstream, in which case they no longer count as extremes. This is why markets haven’t panicked at the prospect of fringe governments: because they have increasing power to keep them on a very short lease.
America, the exceptional nation that it is, featuring the world’s deepest market, the global reserve currency and history’s mightiest military, will of course test the limits of financial market tolerance towards debt. Both presidential candidates promise nothing less than unfettered fiscal spending in the next few years. The almighty Dollar allows them to do so, even if the IMF warned American policy makers to mind the debt.
But for the rest of the world, and especially Europe, the amount of outstanding external debt is enough to give those who would try radical changes pause.
Third, amazing as it sounds, the plurality of outcomes actually still favours the status quo. A fringe leader may or may not be elected. If they are elected, they may or may not last in power. If they do last (or in order to last) they may, or they may not revert to the mainstream.
The reality is that financial markets have (way) bigger problems to ponder on: sticky services inflation and rebounding Chinese producer prices threatening rate cuts, an equity market led by a singular (however magnificent) stock and a rather inexplicable appetite for bonds yielding over 4.5% despite the heavy issuance, are much bigger problems for longer term investors.
The global economy is actually at a good point. It’s slowing just enough to facilitate a few rate cuts, but it’s nowhere near a general recession. This means that corporate earnings, the primary driver of equity prices and primary risk for credit, are not expected to fall off a cliff.
Political uncertainty is, of course a key risk, but by no means the core of investment decisions. Markets consider sticky inflation their most important risk with geopolitics a distant third. Our quarterly investment committee last Friday spent a significantly larger portion of its time debating the course of inflation and rate cuts, the yield curve inversion and the economic realities than the result of political processes, which may or may not lead to significant changes in the status quo at some point in the future.
Speaking of the investment committee, one area that we are becoming increasingly constructive on is Japan, which is finally starting to show real and sustained economic strength, is trading at a discount. There are also additional tailwinds from ongoing corporate reform measures, and as we see the trade war between the US and China ramp up, there is scope for Japan to gain advantage – as a result, we increase our exposure to Japanese equities, whilst reducing our exposure to US value equities.