With 2017 now upon us, it is clear that a new political paradigm has emerged. The prominence of Brexit, Trump, Le Pen, Corbyn, alternative for Deutschland and many others is not the result of idiosyncratic national political issues, they reflect a systemic political shift.
There is clearly a deep feeling of anger and disappointment with the establishment. Besides the fragmentation in politics, the fallout from the financial crisis and the bank bailouts, there are several other factors propelling this disillusionment in large pockets of society. Rising income inequality in developed nations is a key driver, even as global income inequality has actually decreased (the World Bank reports that the number of extremely poor people has fallen 35% since 1990).
Globalisation is seen as depriving the middle classes in developed markets of opportunities and jobs. The resulting anger can be converted into votes. During his campaign, President Trump used foreign trade as a lightning rod in his defence of the beleaguered American middle class. While every economist worth his salt can explain the broader benefits of globalisation, individuals feel threatened and worse off as specific jobs and opportunities move abroad.
Increasing immigration and terrorism have exacerbated this trend. According to BCA Research, 72% of foreign-born workers in the US have at least a high school diploma, which puts them in direct competition with equally educated native born workers.
But what does all this mean for investors?
The cyclical backdrop becomes more challenging in 2017, with the US economy approaching the latter stages of its economic cycle. On top of this, opportunism and isolationism appears to be here to stay. As a result, we are likely to get less fiscal austerity and global trade, alongside more protectionism, political risk, inflation and uncertainty.
This backdrop is broadly neutral for bonds despite the upward pressure on inflation due to increased protectionism, tariffs and taxes. Indeed, we don’t believe we are at the start of a sustained bear market for bonds as high global debt levels make growth vulnerable to higher rates, and we see increased uncertainty and recession risk. This seems to be textbook ‘late cycle’ dynamics, which should provide strong demand for bonds and other safe haven assets.
Growing populism is adding to the challenges for equities in the coming years, given we are moving towards the end of the economic cycle and valuations are already high. In addition, rising barriers to trade and immigration are likely to raise labour costs, especially in regions that are already at full employment such as the US. This, in turn, could lower profit margins. Domestic companies in the US could benefit, while large multinational companies may suffer the most. Open economies, such as Korea and Taiwan, are dependent on world trade, and so could also face headwinds. Although commodity prices could suffer from weaker global trade, gold and especially oil have historically been the most efficient hedges against geopolitical risks.
The illusion of control
The Trump and Brexit victories underscore populism can pop up in any country – even in two of the world’s most capitalist countries. The new commander-in-chief of the free world seems to rule his empire via Tweets rather than traditional policy statements, so who knows what could be said? If a trade war emerges, the precise execution of strikes and counter-strikes will be key to understanding the winners and losers in sectors and currencies, for instance. It is time to expect the unexpected.
We don’t believe there will be any major trends that last for quarters. Instead, we expect momentum in markets to be short-lived and mean reversion to occur regularly. Markets tend to overshoot on newly emerging political risk and correct in the days, weeks or months after the news hits markets. The recent market reaction on the Trump victory only lasted for a few hours. This means it becomes even more important to keep portfolios diversified, liquid, and flexible. Medium-term themes still matter but it is crucial to be nimble and actively trade around these themes as they get quickly get priced in (or out) by markets.
Over the long haul, the degree to which rising populism hurts or helps investors will depend on how far it proceeds. If it simply restores real wages, increases fiscal spending, allows interest rates to come off the zero bound and reduces inequality while restricting some of the trade and labour flows, then the impact on investor portfolios could be reasonably benign.
But if the populist backlash begins to spiral out of control and morph into a trade war or worse, the outcome could be much uglier than most investors currently expect.
Emiel van den Heiligenberg is head of asset allocation at LGIM and regular contributor to the Asset Allocation team’s blog