The past year has been characterised by a series of political shocks: from Brexit to Trump to the Italian referendum. Along with the shock results have been a series of near misses or close calls – the Dutch election and the run-off between Macron and Le Pen in France, for example. And with the UK’s snap election resulting in an unexpected hung parliament, populations are clearly restive.
Certainly, politics appears to have changed. The old left/right axis seems to have been broken. Instead, a globalist/nationalist axis now appears to be in operation. We have seen this most prominently in the US and France, but also to an extent in the UK – think of the Brexit vote and Theresa May’s disparaging reference to “citizens of nowhere”. In the wake of the global financial crisis, ultra-loose monetary policy has benefited asset owners while inequality has widened, and populations are registering their displeasure at the ballot box. Those who feel left behind by globalisation are mounting a significant challenge to the established order.
Investors, however, have grown more sanguine with each shock. The Brexit vote produced a dramatic reaction, but it was felt most heavily in the currency markets, with equity indices recovering swiftly to reach new highs. The recovery after Trump’s victory was swifter still, and the response to the Italian referendum barely registered. At the time of writing, equity markets look to have taken the UK’s hung parliament in their stride. The post-election fall in sterling is positive for the FTSE 100, as many of its constituents earn the bulk of their earnings in other currencies. The gilt market also appears largely untroubled by the outcome.
This year’s succession of new equity-market highs hints at an almost Panglossian optimism. Will this end badly – or have markets simply decoupled from politics? Above all, how should we be positioning our portfolios in this strange new world?
It should be noted that not all of the past year’s major political developments have been unfriendly to markets.
It should be noted that not all of the past year’s major political developments have been unfriendly to markets. The populist tide was stemmed in both the Netherlands and France, where this year’s elections resulted in victories for centrist candidates. In the UK, meanwhile, the election result may even soften the Brexit outcome, given the Conservatives’ need to rely on the Democratic Unionist Party, which opposes any return to a hard border with the Republic of Ireland. Angela Merkel is currently the favourite to win the German election later in the year, but a victory for Martin Schulz’s firmly pro-European Social Democratic Party of Germany would be unlikely to cause alarm. And the French legislative elections look set to strengthen President Macron’s hand.
Another consideration is that developed markets receive significant protection from the strength of their institutions. Donald Trump’s difficulty in implementing the more controversial aspects of his policy programme and the probe into his campaign’s links with Russia are two obvious examples of this. The successful court challenge requiring the UK government to seek parliamentary approval for the triggering of Article 50 also shows the institutional constraints that developed-world governments face.
That institutional strength is often absent, however, in emerging markets. Vladimir Putin, for example, is subject to few, if any, of the constraints that are boxing in Trump. And as the forces of globalisation are often felt more fiercely in the developing world, given the huge disparities in income caused by rapid economic growth, the political response requires very close watching. Ethnic and religious tensions may also be more prominent in the developing world. For example, suspicion of the role of Chinese capital is likely to increase anti-Chinese sentiment across emerging markets as the People’s Republic fills the global role abrogated by Trump’s America. This offers populists further divisions to exploit in countries with ethnic Chinese minorities. So politics is likely to have a greater influence on markets in the developing world than in the developed.
But when we look at market responses to political upsets, we should always remember that humans are remarkably adaptable creatures. What we have seen in the market response to recent political upsets is a ‘Robinson Crusoe’ effect, whereby market participants quickly adapt to their new surroundings. In shrugging off unexpected outcomes, markets are doing the equivalent of donning goatskins and building canoes. They’re simply keeping their heads and carrying on.
We should also recall the Nobel Prize-winning work of George Akerlof. In his seminal paper on the relationship between price and uncertainty, “The Market for Lemons”, Akerlof points out that one effect of uncertainty is that consumers focus on well-established brand names. These “not only indicate quality but also give the consumer a means of retaliation if the quality does not meet expectations”. In other words, uncertainty doesn’t stop consumers from spending or investors from investing, but it does prompt them to favour the names they know well.
How, then, should investors react to all this? First, we should note the shifting sands of politics in the Western world. This may mean more political uncertainty than we have been used to, and certainly more than we have been used to relative to the developing world. More broadly, though, the best response to a febrile and volatile political atmosphere is to focus firmly on corporate fundamentals. By investing in the highest-quality companies, investors not only follow Akerlof’s observation on human behaviour, but also stand to benefit from it, as populations buffeted by political and economic uncertainty react by sticking with what they know best.