In case you haven’t noticed, we are living in uncertain times.
Thanks to the fact that global central banks have printed more money than human beings are capable of comprehending (I mean, we can show the total on a chart, but that’s about the limit in terms of our ability to conceive of it), financial assets have been inoculated.
When stripped down to its simplest possible form, the transmission mechanism to financial markets is remarkably straightforward: policymakers engineer a shortage of purchasable securities and that effort starts with driving yields on the safest of assets to punitive levels. So this works on both the supply and the demand side. You reduce supply by buying up assets, and in the process, you create demand by engineering a hunt for yield. In some cases, the net supply of securities becomes negative.
The great question of our time (or at least for market participants) is whether that powerful technical can withstand epochal political shifts. So far, political earthquakes “the likes of which the world has never seen” (to use a Trumpism) have been overwhelmed by central bank liquidity.
This week, we might have seen the first sign that central banks have reached a limit in terms of their ability to offset geopolitical/policy uncertainty.
That’s the context for the excerpts you’ll read below from a new BofAML note entitled “Separating Political News From Noise.”
Separating political news from noise
The global growth recovery remains on firm footing, with upside surprises to the GDP data in the world’s three largest economies ‒ the US, the Euro area and China ‒ in recent weeks. The main risk to our generally optimistic forecast is a flurry of political events in the coming quarters (Chart 1). Some will have little-to-no macroeconomic impact, but others are potential game changers:
- There are many domestic and geopolitical concerns around the US. We are more sanguine on the former than the latter.
- A hard Brexit and a Catalan secession vote pose major risks in Europe. Italian and German elections should not rock the boat.
- Can structural reform overcome political constraints in EM? We are more hopeful about Argentina and Brazil than South Africa.
US: a melting pot of concerns
There are several political concerns around the US. On the domestic front, Congress will face a huge agenda when it returns from recess on September 5. First on the agenda is the debt ceiling and passing a budget. Recent reports suggest that Congressional Republicans and the White House both favor an increase in the ceiling with no strings attached. That would avoid missed payments. On a similar note, with a full-fleshed budget a long way off, the path of least resistance is yet another continuing resolution, avoiding a shutdown and leaving government spending flat. At any rate, data from 2013 suggest a brief shutdown would not noticeably slow the economy.
Tax reform is probably next on the agenda. We remain of the view that Republicans are too far from a unified plan to get anything done this year. Finally, healthcare reform might resurface. Even in the unlikely event that there are some incremental changes to the ACA, we do not expect them to meaningfully impact growth in the short term.
We are less sanguine on the geopolitical front. The main concerns are deterioration of trade relations with China and the risk of a conflict with North Korea. President Trump has explicitly linked the two issues. China, which accounts for about 90% of North Korean trade, has a unique capacity to destabilize the regime but prefers not to do so due to concerns of a unified US-friendly Korean peninsula. The US administration’s goal is to incentivize China to choose an unpleasant outcome by making a credible threat of a worse outcome ‒ a trade war or military conflict between the US and North Korea. Credibility is key: this is why we expect the US to continue to dial up its rhetoric and keep all options on the table, raising the risk of actual conflict.
The US is also at the center of other geopolitical issues. Congress recently passed a bill that cements the status quo on current Russian sanctions and pushes the president to impose new ones. The latter is not expected imminently, so for now the macroeconomic and market impact of the bill on Russia should be limited.
The final risk to the region is NAFTA negotiation, which is looming large over the Mexican presidential elections, to be held in mid-2018. Talks are scheduled to begin this month, but could extend beyond the Mexican elections. The risk is that the newly elected government could attempt to undo any progress on the negotiations. It also does not help that the elections are likely to be tight: at least three political parties have the potential to get close to 30% of the vote. Rising uncertainty due to these factors in the lead-up to the elections is likely to weigh on growth via delayed investment.
Don’t forget about Europe
European politics have taken a backseat in the news cycle since May’s French election, but will likely return to the spotlight in the fall. In terms of Brexit negotiations, a majority of investors seemingly expect a lengthy transition deal to delay any shock to UK trading relationships. However, there are important risks in the near term. The proposed deadline for finishing talks on divorce terms (bill, citizens’ rights, Northern Ireland border) is October. That looks likely to be missed, delaying the next stage of discussion. The type of transition and final trade deal are “grade A” economic issues as we have written about at length.
In Germany, opinion polls ahead of the September 24 election point to another coalition government led by Chancellor Merkel and waning support for the populist right-wing party. Some form of limited household income support is likely post-election. This should be a modest positive from an economic standpoint. Also, attention might shift to the potential Franco-German initiative for deeper EU institutional integration.
In Italy, general elections are due no later than May 2018. A grand coalition with limited political capital and complicated parliamentary arithmetic is the most likely outcome. As a result, any ambitious economic reform is unlikely and the status quo of structural constraints to potential growth should persist.
Spain will likely be a source of headlines in the fall, too. The potential Catalan referendum on secession, scheduled for October 1, will likely increase confrontation between the Spanish and Catalan governments. Although we remain of the view that the referendum will be stopped by the Spanish government, secession by Catalonia bears major risks, as a disorderly process would threaten the macroeconomic stability of Catalonia and Spain. Further, if the resolution of the Catalan situation proves costly for the current center-right minority government, the risk of its losing power will rise, especially as opinion polls have been moving in favour of the left bloc opposition.
Abe making a comeback?
Prime Minister Abe has reshuffled his cabinet in an attempt to shore up his approval ratings, which plummeted because of a couple of political scandals and his attempt to implement controversial constitutional reform. Although Abe’s ratings have bounced back modestly, he has limited scope to use economic policy to make further gains given the advanced state of the business cycle. Moreover, Abe’s precarious political position introduces the tail risk of a more hawkish BoJ: his tacit support has allowed the central bank to ease aggressively and commit to overshooting its inflation target. We think such a commitment is necessary, not only in Japan, but also in other developed markets.
EM: structural reform, or the lack thereof
In Brazil, corruption allegations against President Temer have derailed the government’s reform agenda. However, we are cautiously optimistic that the recent vote in the Lower House of Congress to dismiss charges against the president will allow for the revival of social security reform discussions. We believe the reforms are necessary for lower structural interest rates and a sustainable path for government spending. A vote on social security reform is expected in September. Passage of the reform remains very challenging: in the best-case scenario, a diluted version of the proposal will be approved. Even this would be a positive, as it would signal strong political support to move forward with other reforms, like tax reform. However, we cannot rule out the risk that the reform agenda will be delayed once more by new plea bargains or charges involving Temer.
Neighboring Argentina is also at a crossroads on structural reform. The mid-term parliamentary elections on October 22 will be critical in determining the government’s ability to implement its reform agenda. Although the ruling Cambiemos coalition is expected to gain seats at a national level, left-leaning former President Cristina Kirchner’s party is leading the polls in the crucial Buenos Aires province. A victory for Kirchner would slow investment at least temporarily as businesses assess the government’s ability to push through its plans. However, an upset win for Cambiemos in Buenos Aires could clear the path for capital market, tax and labor reform, and fiscal consolidation, which would accelerate the economic recovery.
Meanwhile in South Africa, the status quo prevailed as President Zuma survived a closer-than-expected no-confidence vote earlier this week. This leaves us bearish on growth, as the debate around radical economic transformation will continue to be a headwind. Weak growth, fiscal underperformance and potential further deterioration in the institutions of the state are expected to trigger a rating downgrade to sub-IG by mid-2018, which in turn will likely lead to portfolio outflows.
Keep your seatbelts fastened
Global political developments have kept us on our toes and will continue to do so through the fall and into next year. Investors should brace for a bumpy ride, but we are hopeful that above-trend growth has provided the global economy with sufficient buffer to emerge mostly unscathed.