TalkingEconomics: Is populism good for markets?

• Populist policies appear good for markets, which rallied following the Brexit and Donald Trump votes. Looking further ahead though, populist policies to restrict trade and migration are likely to lead to stagflation¹, an outcome that is not friendly for markets.
• Investors are now focused on the French presidential election, where our base case remains that Le Pen is defeated. Meanwhile, the European Central Bank’s (ECB) tone has turned more hawkish but we don’t expect any policy action in the near term.
• In the UK, inflation is soaring. Despite the emergence of a hawk among its policy-setters, the Bank of England (BoE) is likely to keep policy unchanged.
• Trade and emerging market (EM) equities have risen together in 2017, but we do not believe the upswing is secular. Instead, it looks like a cyclical bounce which will likely fade as we move into the second half of the year.

Is populism good for markets?

Populist policies appear good for markets, given the performance of equities following the Brexit and Donald Trump votes. However, we would note that the conditions for a rally (dovish signals from the Federal Reserve (Fed) and signs of a global recovery) were already falling into place last summer, before either of these two events took place.

A populist world economy: fragmented and more inflation prone

What might we expect from a world economy run by populists? How might markets react? One way of looking at this is to think of populism as a reversal of globalisation. Envisage a world economy with far more restrictions on trade and labour mobility.

In such a world, we would expect global trade and growth to be weaker as barriers cut off opportunities. Rather than reaping the benefits brought by specialisation and economies of scale, industries would shrink back to their domestic economies. Productivity, which has benefited from the opening up of competition, would slow even further.

The corporate sector would be at the sharp end of this, facing greater challenges in sourcing labour and importing inputs. Wage growth would likely be stronger, putting pressure on company margins.

Overall we would be looking at a more stagflationary environment, where bond yields are higher and equity markets trade on lower valuations.

Areas dependent on international trade such as Asia would be badly affected. This would encompass a large swathe of the emerging markets, although commodities producers might be better placed as their exports would remain in demand and may even trade at a premium on fears of quotas and loss of access.

There could be more opportunities in markets as divergence increases, an environment well suited to trading strategies that thrive on volatility. There would also be the more specific opportunities created by government policies to protect “strategic” industries. Those lucky enough to be deemed such could enjoy the fat profits of protected markets.

Challenges in the US and Europe; Asia to champion globalisation

Coming back to the immediate situation, we can see some of these trends already playing out in the US and UK. In Europe, populist parties are running in France, Germany and Italy although there is a chance that the mainstream adopts some of the positions of the populists as we have seen in the UK.

Looking beyond the US and Europe, Asia remains relatively free of populist influence. While the West may become more protectionist, the East, led by communist China, could become the champion of free trade.

Eurozone: France heads to the polls as the ECB considers policy

Political risk shifts from the Netherlands to France

Populism suffered a major setback last month when the far-right Party for Freedom (PVV) was comprehensively defeated by the incumbent People’s Party for Freedom and Democracy (VVD) in the Dutch parliamentary elections.

Attention now turns to the French presidential election. Our baseline forecast assumes that either Emmanuel Macron of En Marche! or François Fillon (the Republican candidate) defeat Marine Le Pen of the Front National party, thus avoiding potential market instability. Investors are likely then to flock back to European assets.

If, however, Le Pen does defy the odds, investors are likely to take flight, given concern over France’s euro and EU membership.

ECB hawks are all squawk

Rumours are circling markets that the ECB is turning hawkish in response to the recent rise in inflation. However, inflation is higher due to temporary factors, and is likely to return to lower levels. The ECB’s tone should then become more balanced, and may even return to a more dovish slant.

We continue to expect the ECB to announce a reduction in its monthly purchases from the start of 2018, with purchases anticipated to be phased out by the end the year.

However, it is worth noting that should there be an upset with the French election, we are more likely to see the ECB’s support stay in place, or even expand in order to help support sentiment.

UK: Budget u-turns and the inflation up-turn

The 2017 Budget was largely as expected: growth upgraded, and little done with the extra cash that the chancellor found himself with. Yet the Budget still managed to cause a political storm and an eventual embarrassing policy u-turn.

Meanwhile, UK inflation is soaring (thanks to energy inflation dynamics and a weaker sterling), with further rises on the horizon. Despite the emergence of a hawk among its policy-setters, the BoE is likely to keep policy unchanged given a lack of significant wage growth. After all, with rising inflation squeezing households’ real disposable income, we doubt the BoE would want to add further pressure by raising interest rates.

The global upswing and the EM rally

2017 has started strongly, with growth seemingly healthy and global trade feeling the benefits. This has coincided with a revival in equity markets, particularly in EM.

Can trade momentum persist or even strengthen?

In assessing whether this marks a return to the “good old days” of higher EM activity and equity returns, the first question we ask is why we have seen the recent improvement in trade. Unfortunately, better trade values have not been as a result of a secular change, but rather a consequence of higher prices and stronger global growth.

An ongoing improvement in either of these factors seems unlikely. While we do forecast a mild acceleration in both global growth (from 2.6% in 2016 to 2.9% in 2017, and to 3% in 2018) and inflation (to 2.7% this year from 2% last year, easing to 2.4% in 2018), this is not enough of an increase in either metric to return us to pre-crisis levels of trade growth.

How long can this engine drive trade?

If a secular trade recovery is not on the cards, this implies the current improvement must only be cyclical. Indeed, both China and the US are enjoying cyclical upswings, which have been helping trade, but are likely to fade soon.

Without the support of these two economies, global trade is likely to roll over, at least in value terms, in the second half of 2017. The implication is that this will take EM equities with it.

One hope, however, lies in signs of improving capital expenditure in Germany and Japan, which could allow for some further global trade gains (if read optimistically).

It seems likely then that the EM beneficiaries would change. Historically, eurozone investment has been more strongly correlated with exports to the region from EMEA (Europe, Middle East, Africa) and Asia than with exports from Latin America. Asia also benefits most from a Japanese revival.

So if we do see a rotation in growth leadership from the US and China to Germany and Japan, relative underperformance of Latin America seems a likely result.

^{1. An economic condition in which economic growth slows but inflation rises↩}