Political pressures risk economic fissures
We see the biggest macroeconomic threat facing the world economy at present as fragmentation. A break-up of today’s open markets into smaller trading blocs, as countries increase tariff barriers and restrict the flow of labour, seems increasingly likely.
The fear has been brought into focus by the election of Donald Trump as president of the US, the UK’s Brexit vote and by the rise of populist political parties across Europe. All are looking to close borders to goods and people.
Can the “Trump Bump” continue?
President Trump heralded his decision to cancel the Trans Pacific Partnership (TPP) – the deal to open up trade between the US and much of Asia – as a good one for the American worker. The move, however, runs contrary to the thinking of most economists. The protectionism behind it threatens many of the institutions set up after the Second World War to foster economic co-operation and global prosperity. Higher tariffs may protect domestic industry, but they also mean higher inflation, which, by reducing real incomes, slows spending and weakens growth.
Our analysis of financial markets and economic cycles finds that such a stagflationary mix – when inflation is rising as growth slows – often heralds a difficult period for investors. Central banks seek to protect their inflation goals by tightening policy. Bond yields rise and equity markets de-rate, inflicting losses on investors.
So far, markets have been robust under the new US administration, as investors have focussed on the potential benefits of deregulation and fiscal stimulus. The lack of any follow-through on protectionism will have come as a relief. Deregulation will create opportunities, particularly in banking and the energy sector, but we would be concerned that a significant fiscal boost will push inflation higher.
Is the US overreaching on unemployment?
President Trump has promised to create 25 million jobs, but this seems at odds with the latest employment report that puts unemployment at 7.5 million or 4.7% of the workforce. It is possible that this understates the available labour supply, but even if we make adjustments for part-time and discouraged workers, there are just under 15 million people looking for work. Even this figure is an over-estimate of available capacity, as the unemployment rate rarely falls below 3% and has never fallen to zero in the US.
In short, the US is late cycle, with the economy close to full employment such that supply would struggle to meet the increase in demand triggered by tax cuts or an increase in infrastructure spending. The likely outcome would be an increase in wages and inflation with little benefit to growth. Again, as with protectionism, investors need to be mindful of the prospect for higher inflation and interest rates.
Populism still a threat to euro stability
Europe is the focus now for political risk. The Dutch general election did not deliver another populist shock, as Prime Minister Mark Rutte held onto power. The populist challenger Geert Wilders made little headway. However, this does not mean an end to political risk in Europe. We have a full agenda, including the French presidential election, the German general election and probably an Italian general election.
We think the French and Italian votes carry the most risk. The stakes are high, with leading contenders promising referendums on membership of the EU. Marine le Pen, of the Front National in France, is leading in the opinion polls and is expected to win the first round of voting. She is not expected to win the second round, but this assumes that voters will unite behind whoever stands against her and that the opinion polls are accurate.
The first assumption is probably correct, although maybe challenged in the event of the controversial Republican Fillon making the final round. On the second, however, the experience of the US presidential election tells us simply not to trust opinion polls.
An Italian vote would probably hold more risk. Beppe Grillo’s Five Star movement has closed the gap with the mainstream incumbent Democratic party. There is a real risk of an Italian vote to exit the euro in a referendum in 2018. According to the EU’s own survey through Eurobarometer, Italy has become increasingly pessimistic about the future of the EU, and on balance is negative on its outlook.
An Italian exit, leading to the break-up of the euro, is possible. Although the risk may still be low, the consequences would be immense. Alongside capital flight, we might expect a significant default on Italian government debt - denominated in euros - as a new and devalued currency is introduced.
UK not out of the woods
Finally, in the UK there is a consensus that the economy has shrugged off the effect of Brexit. Economists were too pessimistic about the impact of the decision on growth, but that does not mean the economy is out of the woods. The most difficult period is just beginning as the UK attempts to strike a deal with the EU and uncertainty increases.
Consumer spending, which has kept the economy growing, is beginning to falter as inflation rises. Business investment has already stalled in the wake of the Brexit vote and is unlikely to recover until a deal is done. My concern is that the UK goes over the “cliff”: a member of the EU today, with tariff-free trade with the single market, to being just another World Trade Organisation member the day after.
It is not widely recognised that the UK will be unable to do deals with non-EU countries until it has struck a deal and left the EU customs union, so there will be little to compensate for the loss of access to the single market on exit. Experience says major trade deals take much longer than the two years allocated and, in the absence of a transitional arrangement, the UK risks a very hard landing in 2019.
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