Why did it take them so long ? Political risk is key, and what's the trending theme in politics right now ? You've got it ..... POPULISM !

Wednesday 21st December 2016

Why did it take them so long ? Political risk is key, and what's the trending theme in politics right now ? You've got it ..... POPULISM !

ref :- "Bond Investors Now Losing Most Sleep Over Rising Populism" , Bloomberg Markets

We spend a lot of our time discussing political risk and how it effects markets. It's generally rather more interesting than the dry technical stuff (though not necessarily always more important), and 2016 has seen politics take centre-stage in deciding the fate of investors' portfolios. What's more, 2017 looks like it will bring more of the same, with all of the same potential for shock that has caused such turmoil in markets over the last six months. Who's to say that the ride to come won't be even bumpier than what's gone before ? 

Bank of America Merrill Lynch's Global Research department put out a report on Monday in which they'd asked bond investors to identify what they each regarded as the biggest threat to bond markets in 2017. In joint third place were Evaporating Liquidity (which seems reasonable enough given the concerns over algorithm-driven trading, regulatory costs incurred by market-makers and the increasing likelihood of "flash crashes"), and ECB Policy Failure (where do you start on that one?).

At No. 2 on the list with 13% was Rising Yields  --  sounds a bit obvious, doesn't it ? As yields rise so prices fall, so naturally this must be A BAD THING for investors, surely. That's right , but what's being referred to here is a fundamental change brought on by rising government debt levels, rates, commodity prices and growth. 

And at No.1 ? You've guessed it ...... politics. But not just politics ..... the narrow and in years gone by relatively unimportant brand of politics we know as Populism.  As recently as October, 9% of those surveyed listed populism as their biggest concern  --  now it's 31%. If investors failed to fully appreciate what the Brexit vote in June signified as evidence of the march of populism , the Trump victory looks to have opened their eyes. So too did the rejection of PM Renzi's constitutional reform proposals in the Italian referendum in early December. This wasn't exclusively a victory for populism, but it does throw Italian politics into a situation where populist opposition parties have an increased chance of grabbing a share of power.

Markets are still struggling to come to terms with the repercussions of Trump's win ..... which is not a total surprise as we still don't know exactly what forms his policies will take. But the assumption is that higher infrastructure spending plus tax cuts must lead (in the short-term at the very least) to higher levels of government debt, higher inflation, higher bond yields and lower bond prices. The adjustments to bond markets used to ultra-accommodative central banks has been both sharp and painful, and they're wary of getting caught out again.

As well they might be ..... elections loom in France, the Netherlands and Germany (and probably in Italy too). Nobody is glibly writing off the chances of populist gains as they might have done a year ago, or at least they shouldn't be. Anti-establishment, anti-globalization figures are gaining support across Europe and every banking crisis or terrorist act will only add to their attraction.

We can see what bond investors are doing in expectation of Mr Trump's policies. High government infrastructure spending means money moving out of US Treasuries and into corporate bonds of companies likely to benefit from that spending. There has also been a move out of longer debt (10 years +) that is extra-sensitive to inflation concerns (by 54% since October in the corporate sector). But on just how to best position ourselves in the event of further populist triumphs in 2017, and the danger those would spell for the EU, sadly the article is less forthcoming.

From what we read, we assume that 2017 will be the year for the "active" investor. In the US, gone are the days when one could expect monetary policy to support every asset class and one will have to be prepared to cherry-pick those that will benefit from the the new regime. In Europe, there's an argument that says large parts still need further monetary assistance, though they are unlikely to get it. But neither will they see any tightening immediately. For Europe, it's politics, and populism, that could put the cat amongst the pigeons.