Markets are recalibrating after the political shocks of the last few months. First Brexit, now Trump – and next? Will anyone be truly surprised if Renzi loses the Italian constitutional referendum or Marine le Pen puts in a strong showing in the French Presidential election? Or if Germany’s Eurosceptic Alternative Für Deutschland party gains a stronger voice in next year’s election? Local and national differences shouldn’t be understated, but there is, of course, a common thread running through these elections: an angry reaction by a demographic group feeling left behind by social and economic change, feeling cut off from opportunity and the drivers of growth in the economy. They find they have no voice for their concerns in the established, mainstream politics of centre-right or centre-left and see in globalisation, free trade and immigration a convenient target to blame.
Perhaps the wrong target, or at least a gross oversimplification: education, skills, technology and the rise of automation surely play at least as much of a role as globalisation in the dislocation of workforces in the developed world. But resentments harnessed by new political forces and the establishment have not yet delivered a satisfactory answer. There seems little reason to expect this populist wave to break yet; indeed it may take worrying new directions if Brexit or Trumpism fail to live up to campaign promises. There are signs of a pragmatic softening already. Indeed, Trump’s acceptance speech focused on tax cuts, infrastructure investment and reconciliation with both mainstream Republicans and Democrats rather than on trade barriers and deportations.
Markets were shocked at first by Trump’s win, with wild moves in the small hours of November 9, but the shock passed quickly. We have moved rapidly from a situation where few expected a Trump win and most expected that markets would react badly to such an outcome, to the reality of a Republican clean-sweep of Congress and the White House. Instead, equity markets are focusing on the potential positives, we have an administration with a mandate for change, significant infrastructure spending plans, and proposed tax breaks for households and business. All of this could support growth. Markets, of course, are sensitive to the political risks too, in particular trying to price in the risks of a US retreat from global free trade and long-standing military alliances. Emerging Markets (EM) have borne the brunt of this concern, notably the Mexican Peso.
But the crucial question of how much of Trump’s campaign rhetoric materialises as firm policy and how much is pared back to prosaic reality remains unanswered. We had trimmed EM assets before the election to protect ourselves against a surprise Trump win. Our remaining EM positions (in equities and bonds) have been hit, but there is a clear risk that markets could be over-reacting. After all, pro-growth policy in the US, promoting consumer spending and infrastructure investment, is not necessarily bad for global demand and for EM exports, so long as the wilder protectionist ideas are reined in. Of course, there is uncertainty about geopolitical risk in the emerging Trump world. In the immediate relief rally, safe haven assets have lost ground, but we still see a case for owning assets like Gold and the Japanese Yen, which have scope to rebound if early optimism fades. There seems little reason to expect this populist wave to break yet; indeed it may take worrying new directions if Brexit or Trumpism fail to live up to campaign promises.
We may be facing a potential regime shift in economic terms as well as political. Markets see Trump’s policies – if enacted – as inflationary. Significant deficit spending and the possibility of disruptions to free trade could reinforce existing inflation pressures in the US. Bond yields have already risen sharply in response (our portfolios are relatively sheltered from this, with very low exposure to government bonds) and market expectations of inflation have shifted meaningfully higher. Our inflation protection certificates capture this shift well. But there may be a more profound debate playing out in markets: is the economic regime finally shifting from the dominance of monetary policy and quantitative easing over the post-crisis period, to a new regime dominated by government spending, infrastructure investment and tax cuts? Will we see governments, led by the US, respond to low bond yields by dramatically increasing fiscal deficits? The sweeping political change in the US and UK, and the changing tone of central bank policy pronouncements, suggest this is a serious possibility.
It would have deep consequences: what worked well in markets in the old regime could unravel. Investors would need to respond to the possibility of serious losses not only in their ‘safe haven’ bonds, but also in defensive, high-yielding stocks. It would favour floating rate and short-term debt over fixed rate bonds, and cheap cyclical stocks and sectors, particularly those that benefit from steeper yield curves – notably financials, which may also benefit from a more sympathetic tone in regulation.
The new political landscape is uncertain, but we should resist the temptation to avoid risk at all costs and should look to back opportunities where we find them. We have held high cash allocations in portfolios over the past few months in order to have exactly that flexibility. Scope for higher growth in the US and relief for the banking sector as yield curves become a little steeper are just such opportunities. We have added to US equity, focusing on mid-caps and on financials, and we have cut exposure to US Treasuries. From here, we have scope to flex portfolio positioning as the new regime takes shape.
Deputy Chief Investment Officer
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