Political Risk Update
Political Risk Update
The UK’s transition of power will score well against other democratic benchmarks.
This article first appeared here.
The long-anticipated rate-cutting cycle in the West’s major economies is underway. The Bank of Canada and the ECB were the latest to cut. However, both were careful to state that their stance remains restrictive, and investors should not necessarily expect further cuts to follow soon. The fight against inflation is not over, and we were again reminded that their future decisions will be data-dependent. To reinforce this message, the ECB revised its forecast for inflation upwards as it announced its 25-bps cut. The Bank of England would have also cut by now if it weren’t for the election.
Mixed signals about the US economy cast doubt on the timing of the Fed’s rate cut decision. However, the Fed helps investors by publishing a dot plot illustrating the collective wisdom of the FOMC’s forecasts of future rates. On average, it now only sees scope for one 25-bps reduction this year, which is disappointing compared to previous estimates.
But, by the end of next year, just 18 months from now, the spread of dots plotted by FOMC members ranges from 2.75% to 5.25%, formed from a range of opinions about the US economy’s prospects. This is undoubtedly the result of a wider-than-normal gap between the performance of different sectors, which, in turn, mirrors the gap between tight US monetary policy and its loose fiscal policy.
We said in February,
Who knew that putting your feet simultaneously on the brake and accelerator could lead to unexpected results? However, the current economic data still suggest growth, albeit with significant sector variations.
Despite this confused picture of the course of the US economy and the future path of dollar rates, the 10-year US Treasury yield fell 25 bps following the Fed meeting. Was the market thinking this was good news, or was it due to bad news elsewhere? It was both, and politics was the main worry.
Political uncertainty is a continuing feature of 2024; elections in India, South Africa, and Mexico have all induced local financial uncertainty. Last weekend, it arrived in the EU, specifically France. Following President Macron’s surprise decision to call a snap National Assembly election, the yield premium on French bonds (to the benchmark German bund) blew out to levels not seen since the European Debt crisis over a decade ago, weakening the Euro.
With typical bluntness, fund manager Barry Norris of Argonaut Capital said of the situation,
The success of European elections for parties termed populist or far right by the sneering classes but who articulate the growing frustration of culturally Marxist ideologies, whether that be wokeism, climate change alarmism, or immigrationism, all of these perceived to undermine standards of living and national identity. There is a risk that this political backlash within the EU is underestimated. Calling early parliamentary elections, President Macron may also be underestimating the seriousness of the situation. It is quite possible that we are seeing the beginning of the end for both Net Zero and the EU.
While one might consider Barry’s view extreme, with Belgium and the Netherlands unable to form national governments, France on an electoral knife edge, and Germany’s coalition government looking unelectable, it is unsurprising that investors are nervous about the EU’s ability to fiscally consolidate. This spate of Euro market nerves is not over. It could escalate and become contagious.
Of course, the UK also has an election, where a change of government looks certain. However, the risks involved don’t compare to across the Channel. Since Q4 2022, the UK has effectively had a caretaker technocratic government run by two chancellors under strict fiscal guidelines imposed by the OBR (Office for Budget Responsibility) and enforced by the bond markets. Any new government is unlikely to deviate from this plan in the near future, the main reason the Pound has been one of the most stable currencies over recent months.
Last week, the UK became the first major Western economy in this cycle to report an annual inflation rate at the target of 2%. Meanwhile, the UK’s annual GDP growth is better than expected, and real wage growth is at its highest level since the GFC.
Although the UK faces many issues, its fiscal course is comparatively secure, understood and priced in by financial markets. Its assets, under-allocated by global investors for many years, are cheaper than those of other markets, which typically have similar levels of growth but often with increasing political uncertainty.
Emma Duncan recently wrote in the Times
If Britain were a stock, I’d buy: the price is low, the fundamentals are good, and the quality of governance is bound to rise after the election … What Britain needs is investment, and what investors need is stability. That’s precisely what has been lacking for the past decade. Business investment as a share of GDP stalled in 2016, while it continued its normal trajectory elsewhere in the world. Uncertainty, as much as Brexit, explains Britain’s underperformance.
While nothing is certain in our chaotic world, some trends are discernible. As we have commented, the UK has spent its time on the investment naughty step in recent years. We highlighted the previously unthinkable in March that investors were starting to see the UK as a safe haven; this remains our view and this trend has further to travel.
We said in January,
The UK’s transition of power will score well against other democratic benchmarks. This should be sufficient for global investors seeking certainty to boost net capital flows to the UK.
Let’s hope so.
Jeremy