Head of Fixed Interest Research
Populism appears to have been the dog that hasn’t barked over the past few years. While populists have won notable victories in the US, UK and Italy, there has been relatively little fallout for investors. For some asset classes, you could even argue that populism has had a net positive effect, with Donald Trump’s tax cuts delivering a large boost to company earnings and the US economy overall.
Since the beginning of 2016, US shares are up by around 40%, making for an impressive annual return of 12% a year. While that figure is flattered by the dates chosen, what we essentially have is a populist paradox, with companies doing well despite the volatile turn politics has taken.
Given the failure of populist rhetoric to turn into action, some investors have been tempted to disregard politics. We might term these the ‘blood on the street’ investors, after the Baron de Rothschild who made a fortune in the panic that followed the Battle of Waterloo. While we would agree with a cool approach to populism to a certain extent, the concern today is how strong populism is, despite a decade of steady – if subpar – growth in the US and UK. Clearly, the economy is not working for everybody, and political pressures are only going to intensify when the economic cycle turns down.
These economic issues are compounded by the fact that the authorities have limited room for emergency measures. Interest rates in the UK and eurozone are at or close to record lows, leaving little room to stimulate the economy when the next downturn arrives. The problem is less acute for the US, which has raised interest rates significantly over the past three years, and which has even made a start on unwinding quantitative easing.
Paradoxically, however, the US is where we might see truly radical policies soonest. We are about eighteen months away from another presidential election, and Democrat candidates are beginning to throw their hat in the ring for a presidential run.
It is Trump’s tax cuts which are really stirring up US politics. Trump has piled on the debt at a time when the economy was not in need of government stimulus, opening up the door to Democrat demands for spending on everything from free tuition fees to improved medical care coverage.
There seems to be a growing acceptance in the US to spend whatever is needed. Interest in previously obscure economic theories such as Mainstream Monetary Theory (MMT) has grown, with MMT even entering the political vernacular in the UK. Several members of Labour’s economic team are supporters, and features have begun to appear in magazines such as the New Statesman.
Modern Monetary Theory’s central contention is that so long as a government operates its own currency, inflation is the only constraint on how much can be borrowed. Good news for left wing populists in the US or UK, not so much if you’re the Greek finance minister and have to run the idea past Angela Merkel first. There are more complicated economic questions around the theory, but our simplified version of MMT is essentially what is catching the interest of the politicans.
The catch of MMT is that governments would need to reduce spending if inflation picks up. Tax rises or spending cuts are never popular, and implementing them on the basis of a relatively esoteric concept like inflation seems even less likely to be a vote winner. While financial markets are not showing much concern about MMT at the moment, there is a risk that theories like MMT encourage the US to not tackle its growing deficit. Failing to do so will have long-term implications.
The eurozone probably has the most intractable problem with populism. However, the region is probably the least likely to see damaging populist policies being enacted in the short term. The structure of the eurozone limits the freedom individual governments have, including how much they can spend and changes to trade or competition policy.
The problems underpinning European populism are the hardest to solve, largely because they require support from different electorates across Europe. While the European Central Bank (ECB) bought some time for reforms over the past few years, European politicians have largely squandered the opportunity to undertake reforms.
Ideally, investors would need to see a proper eurozone banking union to prevent another eurozone crisis. This is where the eurozone as a whole guarantees the safety of member state banks. The current situation, where individual countries guarantee the safety of their banks, can lead to markets losing confidence in a country’s finances and its banks by extension, leading to a vicious circle of falling growth and deepening uncertainty.
For Europe, the limited room for manoeuvre in terms of traditional economic policy has become very real in the past few months. The downturn in the eurozone economy has taken many by surprise, coming just three months after the ECB stopped one of its main programmes to support the economy.The central bank reversed course in early March, announcing that they would keep interest rates on hold to 2020 and making a fresh offer of cheap funding to the region’s banks. While markets welcomed the move, they soon questioned whether it would be enough.
A further risk is that the leadership of the ECB is now up for grabs. Mario Draghi, the man credited with ending the eurozone crisis after pledging to do ‘whatever it takes’, retires in October this year. With Draghi having effectively saved the eurozone single-handed, questions are being asked as to who can live up to his legacy.
The majority of the frontrunners to succeed Draghi tend to share his policy views. One notable exception, however, is Jens Weidman, the current president of the Bundesbank, the most influential member of the European Central Bank. Weidman is known for taking a hard line against quantitative easing, essentially viewing the ECB programme as rewarding financially profligate European countries through the back door.
Media headlines often tend to be over-sensationalist when it comes to populism. It’s a mistake to think that investors will suffer just because a populist candidate or party comes to power. But there is also a risk, especially after the past three years, that investors become complacent about the potential for change.
Based on nothing more than the length of the economic cycle, it is likely that we will see a recession in the next five years. Given the level of support populism has at the moment, we can only expect the pressure for change –and radical solutions – to rise. That will not necessarily be bad for investors. It might be that the authorities manage to develop new solutions, so-called policy-innovations, that help to support the economy and begin to feed through into people’s everyday lives.
One possibility is for a central bank like the Bank of England to simply write a cheque to everyone to encourage spending. That suggestion might have seemed outlandish fifteen years ago, but so would the notion of nationalising banks like Northern Rock. It would be wrong not to be thinking about what the financial authorities do next.