Three reasons why politics haven’t panicked markets

Apart from slightly lower core inflation data in the US, it was a rather quiet week in markets. The investors’ focus was on the French parliamentary election, the US presidential debate and, of course the upcoming UK election.

At the time of writing (Monday morning), Marine Le Pen’s party had turned the tables on Emmanuel Macron and won a large part of the popular vote in the first round. However, market reaction was by and large positive, as pundits now think that a Le Pen government might be a more difficult proposition in the second round. I’d wait for the second round before drawing conclusions, however, as these sort of elections depend on second-round alliances.

In the US, the presidential debate turned into a lucidity and coherence contest between the two candidates. Whoever wins, plenty of Americans feel short-changed by the presidential choices of the two major parties.

And in the UK, anything other than a landslide victory for Labour on the fourth might be considered a surprise by markets.

All that is fascinating. My one political conclusion from these developments, is also an economic one: Governments have been running big fiscal deficits for some time. Eventually, the mainstream governments ran out of fiscal space, which has turned voters to more extreme choices that promise different outcomes. Put it differently, the preference of many voters towards the political extremes means that constituents, desperate for real economic growth, prefer those who promise change rather than the status quo, action over inaction.

However, we don’t think investors should necessarily be afraid.

For one, political extremes are usually short-lived. What used to be the fringes still need to deliver successful outcomes to remain in power. My own experience has taught me that populism, which is nothing more than the promise of a successful change of the status quo, runs in cycles. If the promisors fail to deliver, and they often do because reality checks their extravagant promises, then normality resumes. Voters have vented and mainstream parties have tried to reinvent themselves, so a return to the political centre is the more likely outcome. Politics move fast these days. The easier it becomes to grab power, due to souring political sentiment, the more difficult it becomes to hold on to it for the longer term.

Second, financial markets determine the behaviour of governors. The more debt grows, the more a country is sensitive to bond market oscillations.This was the lesson taught to Ms Truss and Mr Kwarteng. A lesson learned by Italian PM Meloni, as well as Madame Le Pen who quickly toned down her rhetoric at the prospect of true power. To survive, the extremes need to be brought to the mainstream, in which case they no longer count as extremes. This is why markets haven’t panicked at the prospect of fringe governments: because they have increasing power to keep them on a very short lease.

America, the exceptional nation that it is, featuring the world’s deepest market, the global reserve currency and history’s mightiest military, will of course test the limits of financial market tolerance towards debt. Both presidential candidates promise nothing less than unfettered fiscal spending in the next few years. The almighty Dollar allows them to do so, even if the IMF warned American policy makers to mind the debt.

But for the rest of the world, and especially Europe, the amount of outstanding external debt is enough to give those who would try radical changes pause.

Third, amazing as it sounds, the plurality of outcomes actually still favours the status quo. A fringe leader may or may not be elected. If they are elected, they may or may not last in power. If they do last (or in order to last) they may, or they may not revert to the mainstream. 

The reality is that financial markets have (way) bigger problems to ponder on: sticky services inflation and rebounding Chinese producer prices threatening rate cuts, an equity market led by a singular (however magnificent) stock and a rather inexplicable appetite for bonds yielding over 4.5% despite the heavy issuance, are much bigger problems for longer term investors.

The global economy is actually at a good point. It’s slowing just enough to facilitate a few rate cuts, but it’s nowhere near a general recession. This means that corporate earnings, the primary driver of equity prices and primary risk for credit, are not expected to fall off a cliff.

Political uncertainty is, of course a key risk, but by no means the core of investment decisions. Markets consider sticky inflation their most important risk with geopolitics a distant third. Our quarterly investment committee last Friday spent a significantly larger portion of its time debating the course of inflation and rate cuts, the yield curve inversion and the economic realities than the result of political processes, which may or may not lead to significant changes in the status quo at some point in the future.

Speaking of the investment committee, one area that we are becoming increasingly constructive on is Japan, which is finally starting to show real and sustained economic strength, is trading at a discount. There are also additional tailwinds from ongoing corporate reform measures, and as we see the trade war between the US and China ramp up, there is scope for Japan to gain advantage – as a result, we increase our exposure to Japanese equities, whilst reducing our exposure to US value equities.

George Lagarias, Chief Economist

Market update

equities initially welcomed a decrease in the monthly rate of core PCE inflation, but later dipped on the release of consumer sentiment data, which was stronger than expected. In the end, US stocks finished the week flat in GBP terms. UK and EU markets were the point of weakness this week, falling by -0.8% and -0.5% respectively, as elections in the UK and France loom. Japanese stocks rallied, while the Yen weakened, leading to a 2.5% return in GBP terms.

Yields of 10-year government bonds rose modestly over the week, with UK gilts advancing by 9 basis points, US treasuries by 13 basis points and German bunds by 7 basis points. News on US durable goods orders, core PCE, and consumer sentiment were watched by bond markets.

Gold rose by +0.3% over the week, while oil advanced by 1.4%.

Macro news

The UK economy grew faster than previously estimated in the first quarter. According to the updated figures from the ONS, UK GDP increased +0.7% in Q1 of this year (revised up from 0.6%). This was the fastest UK growth rate since the end of 2021, confirming the end of last year’s technical recession, and the highest of any G7 countries.

Inflation in France fell to 2.5% year-on-year in June, slowing from 2.6% in the previous month. A slowdown in energy and food prices contributed to the fall in headline inflation, according to figures from the National Statistics Institute. This is the first inflation figure for the eurozone to be published for June and is a sign that inflation in the bloc is continuing to slow.

The Japanese Yen hit a near-38-year low against the U.S. dollar, weakening to 160.82 according to FactSet data. This breach of the previous record set on April 29, 2024, raised expectations of possible currency market intervention. It’s the Yen’s weakest level since 1986. Authorities are closely monitoring the situation and may take action to stabilize the currency.

The week ahead

Investors will be watching the Eurozone’s latest inflation and employment data, which will be reported on Tuesday this week. Minutes from both the European Central Bank and the US Federal Reserve’s latest meetings will be released midweek.