Poor politics containing bond market risks?

1 October 2018

As September and Q3/2018 drew to a close, investors enjoyed a second consecutive week of positive returns, ending the period not only with positive returns overall, but also in an uptrend. This must have been all the more confusing for those who follow politics more than the economy and capital markets. In the UK, the volume of the domestic Brexit debate is gradually rising to a crescendo, in Italy the populist government agreed on a near doubling of the budget deficit which was met with disapproval from the EU and finally the tone between the US and China over the trade conflict deteriorated to the ‘not-talking’ level.

Cynics argued that stocks only rose because in light of rising inflation, investors shunned bonds and cash which only left equities as the least worst option. While there is some truth in this, it is nothing new. Not even that the US central bank, the Federal Reserve, raised rates again and for the third time this year to now just over 2%.  The real news was that the US rate setters dropped the word ‘accommodative’ from their accompanying notes that describe their monetary policy.

Before the Global Financial Crisis (GFC) ten years ago this would have been a relatively regular change in central bank policy communication, but today it marks the end of one of the longest ever periods of extraordinary monetary accommodation. As such it was greeted as another sign that the global economy is further progressing on the gradual path of normalisation back to the ‘old normal’.

Indeed, the global economy and capital markets appear remarkably robust in terms of consistent but not exuberant growth. The same cannot be said about the political environment, where the upheaval of the economic damage and financial aftermath of the GFC has led to an unexpected level of instability – with an immense time lag.

Political representatives of the traditional parties these days appear incapable to provide the stability of framework economies require to thrive. Their fearfulness that their electorates will succumb to the siren calls of populist politicians if they dare to support slightly more complex and cooperative routes to collective benefit rather than the simplistic self-interest of ‘we win – you lose’ is leading to increasingly bizarre results. Case in point is the UK, where neither of the two dominating political parties dares to admit to the public that any form of substantial exit from the trading framework of the past 40 years will at least initially worsen economic standards.

In the absence of constructive political debate, it is left to journalists, business and trade representatives to take hold of the debate. It seems very unorthodox that it is the non-political leaders of society who feel obliged to create a sense of urgency by pointing out uncomfortable truths and inevitable consequences of politicians’ current course of action but also identify the more constructive paths towards solving the looming ‘impasse’.

No wonder the British public is becoming increasingly alarmed as the press no longer merely reports and comments, but seemingly exaggerates deliberately in order to force politicians to take constructive action. It is sadly fact that in the first 2 years of Brexit negotiations very little progress has been made towards establishing mutually acceptable and constructive terms of an exit. While this is mostly blamed at individuals I suspect it is more likely the consequence of the vast majority of the political and administrative leadership of the UK being unconvinced of the benefits of a Brexit.

In such an environment of political indecisiveness it strikes me as very unlikely that far reaching economic decisions can be executed by weak political leaders. Much more probable that either a muddle through around some compromise relatively close to the status quo is pursued or the proverbial can is kicked further down the road – towards a further extension of the transition period, as now frequently suggested. Neither would be ideal, but certainly far less dramatic than the different opinion influencers are trying to portray April 2019 to be. I take comfort that capital markets appear to see it similar, with the value of £-Sterling recovering towards its pre-Salzburg levels rather than taking much note of the rising crescendo of the no-deal Brexit scaremongering that took hold of the public debate over the week.

In the US where a populist is in power the situation is slightly different. Trump’s fiscal stimulus fireworks are beginning to shine less brightly, while the potential for collateral damage from his trade disputes with China are beginning to hold back business investment. The free trade agreements his administration reached this week with both South Korea and Japan make it seem less likely that the US will descend into a global trade war, but there are various rational arguments that suggest that Trump’s America First dispute with China is not ending any time soon.

The difficulty is that rational arguments require rational politicians or at least decision making that follows historical precedent. Neither can be assumed for Trump and so it is preferable to go by those metrics that are more predictable. From this angle, the decoupling of US growth and stock market valuations from the rest of the world ended or at least paused over the course of September. Europe has not quite taken back the lead, but Japan’s and the previously beaten up UK stock markets did.

In Europe much focus was once again on Italy, with fears for its bond market dragging down equities as the populist government hiked the budget deficit to 2.4%, much to the disapproval of the EU’s leadership. We would note that 2.4% remains substantially below the EU’s imposed 3% of GDP deficit limit while also still constituting a primary budget surplus – before interest payments. We are not the only ones who believe that Italy should be permitted some fiscal slack given its economic reform burdens and the fact it shoulders much of Europe’s immigration pressures from Africa. Germany’s politicians would do well to remember that they exceeded the EU’s budget guidelines far more substantially in the early 2000’s when they had become ‘the sick man of Europe’.

From this perspective the pressure on Italian bonds appears somewhat an overreaction, although admittedly it should serve as a warning shot to the populists in government that if they take their fiscal initiative any further, then every additional Euro of stimulus may lead to an equal or higher debt servicing burden for Italian businesses, households and the government itself.
From this perspective it is not too far off the mark to conclude that the strong economic upward momentum which at the beginning of the year had led to fears of a disorderly bond investor exodus, has now been largely contained by political malfunctioning. The robustness of the global economic growth picture should mean that upward momentum can be maintained despite the political headwinds, while an overshooting that would destabilise fragile bond markets should be contained for the foreseeable future. From this angle it may be more understandable why stock markets have had a good September, even though political progress seems to have gone into reverse.