When it comes to heightened political risk, there is no shortage of hot spots. Last Friday, Argentina’s currency, the peso, sank to a fresh low against the US dollar partly because of fears that the decision by the country’s president, Mauricio Macri, to ask the International Monetary Fund for an aid package to shore up the economy lacks popular support. The country is still traumatised by the pain inflicted by previous IMF-backed adjustment programmes.
Two days earlier, the stunning victory of Mahathir Mohamad in Malaysia’s parliamentary elections fuelled concerns that he will endanger Malaysia’s fiscal position by scrapping a goods and services tax which, although unpopular, has become a crucial source of government revenue. Mahathir is renowned for his distrust of currency speculators and his imposition of capital controls during the Asian financial crisis,
In Italy, meanwhile, a deal between the two anti-establishment parties viewed as the winners of the country’s inconclusive parliamentary election in March is likely to result in the formation of the first government of a leading European economy that is openly hostile to the rules underpinning the euro. The nation with the second-highest public debt burden in Europe and with one of the most vulnerable banking sectors appears set to be governed by a populist-nationalist coalition.
The global economic backdrop … remains benign while corporate fundamentals are solid
There are plenty of other sources of political risk, including the politicisation of monetary policy in Turkey which is contributing to the sharp slide in the country’s currency, the lira, and, more worryingly, the increasingly protectionist policies of US President Donald Trump which have led to a severe escalation in tensions over global trade.
Yet despite the increase in market-unfriendly political developments in both advanced and developing economies, there is scant evidence that these threats are affecting broader sentiment in global markets.
Many commentators in the financial media take this as a sign of complacency by international investors, engendered by years of ultra-loose monetary policy which have distorted asset prices and desensitised markets to all sorts of risks and vulnerabilities in the global economy.
But is this really the case?
Regarding Argentina and Turkey, the two countries which have borne the brunt of the recent sell-off in emerging markets, JPMorgan is right to note that “idiosyncratic” factors are at play, notably both nations’ excessively high inflation rates and their large current account deficits. The global economic backdrop, on the other hand, remains benign while corporate fundamentals are solid.
Last week, the benchmark S&P 500 equity gauge enjoyed its best week in two months in response to the stellar earnings of companies in the index, with the S&P 500 on track to post a whopping 24 per cent rise in corporate profits in the first quarter of this year. Moreover, while the euro-zone economy has slowed markedly this year, global growth still managed to expand modestly at the start of the second quarter, led by a robust US economy, according to the latest JPMorgan Global Manufacturing and Services Purchasing Managers’ Index, published earlier this month.
An ‘Italexit’ … would decimate the euro zone and is therefore highly unlikely to materialise
Yet, the most important reason why investors can afford to brush off the recent increase in political risk is that none of the sources of instability present a systemic risk to the global economy.
Even in the case of Italy, which poses the most serious threat because of the size of its economy – the third largest in the European Union – and its potential to rekindle fears about the sustainability of Europe’s shaky monetary union, the two populist parties poised to form a government have already backpedalled on their plans to take Italy out of the euro. An “Italexit”, moreover, would decimate the euro zone and is therefore highly unlikely to materialise.
Yet, just because political risk in itself is not a sufficient reason for markets to fret does not mean investors are not being complacent.
It is striking that the VIX Index, a popular measure of market volatility dubbed Wall Street’s “fear gauge”, is more or less back where it stood in late January just before a sharp increase in turbulence that was exacerbated by the sudden unwinding of highly leveraged bets on volatility remaining subdued.
Since then, the potential catalysts for further volatility have increased significantly and include the escalation in trade tensions, mounting concerns about the strength of Europe’s recovery and, most importantly, the determination of the Federal Reserve to raise interest rates more aggressively, increasing the scope for a policy mistake.
Investors are right to shrug off country-specific political risk. But they are wrong to assume that market conditions are as favourable as they were in late January.
Nicholas Spiro is a partner at Lauressa Advisory