Global Market Watch: What Could Derail the Rally? In a Word, Politics

Markus Schomer, CFA
Chief Economist
New York

31 October 2017

Global financial markets have stretched this year’s risk-on rally into the fall. By now, most markets – equity or fixed income – look expensive based on historic valuations. However, it is hard to imagine a sustained correction as long as central banks continue to print money. The Federal Reserve may have started the process of balance sheet reduction. Yet both the European Central Bank (ECB) and the Bank of Japan will continue their asset purchase programs through all of next year – and in the case of Japan, well beyond. Further market support comes from improving global macroeconomic fundamentals.

That was underscored by the International Monetary Fund’s (IMF’s) bullish October “World Economic Outlook,” which upgraded the fund’s global growth forecasts for the second time this year. With monetary policy and global macro fundamentals pushing markets higher, politics remain the main risk. At the start of the year, we highlighted the list of potentially disruptive 2017 elections. So far, none has had a sustained market impact. Yet a number of political events could still result in major policy changes in the next nine to 18 months and affect market performance.

European elections have gone well so far …

In Europe, the main theme in the first half of the year was the success of mainstream parties in elections in the Netherlands and in France, which seemed to reaffirm the commitment to further EU integration. In September, Germany's ruling center-right conservatives added another vote for the status quo in Europe, but Chancellor Angela Merkel’s Christian Democratic Union now faces difficult talks to form a three-party coalition with the pro-business Free Democratic Party and the Green party. Failure to reach an agreement could trigger new elections and would raise the risk of greater political instability. Success should open the door for more expansionary fiscal policy, with tax cuts and increased spending the likely price to get all parties on board.

… but Brexit negotiations have stalled …

However, not all is rosy in European politics. Specifically, the Brexit negotiations aren't going well. After wasting the first two months of the year with an unnecessary election that the ruling Conservatives managed to lose, the UK government has been mired in infighting, leaving negotiations stuck in first gear. The reality is that the EU is in full control of the agenda and the UK has more to lose. A strong Prime Minister would agree in principle to an exit bill to move on to trade talks and the ultimate price for the UK in order to preserve access to the single market for Britain’s financial industry. Toying with a “No-Deal Brexit” risks not only an adverse affect on the City but also damaging the UK's reputation as a reliable destination for foreign direct investment. It's time for the government to understand what is at stake and cease looking at the EU as an adversary. What are future potential trade partners supposed to expect when the UK keeps invoking war references in negotiations?

… and then there’s Catalonia

Another political problem for the EU is the standoff between the government of Spain and the region of Catalonia. After winning a referendum that the central government had declared illegal, and which had a turnout of less than 50%, Catalonia's parliament declared independence at the end of October. That in turn prompted the Spanish government to dissolve the regional assembly and establish direct rule from Madrid. The situation is still unresolved, and new regional elections may produce a similar majority for parties supporting independence. The EU has so far steadfastly supported the Spanish government. However, Catalonia is no singular problem. Italy and Belgium have regional autonomy movements that could trigger similar crises. The EU cannot ignore the democratically expressed will of the people in current member states while quickly offering membership to every newly independent country in Eastern Europe. The EU should encourage member states to grant regions greater autonomy, which may eventually include a new representative institution in Brussels.     

Xi sets China’s agenda

The 19th National Congress of the Communist Party of China was an event designed to complete President Xi Jinping's consolidation of power. In a departure from precedent, the Congress did not appoint an heir apparent to take over after Xi’s second five-year term ends in 2021. That may indicate Xi intends to hold on to power beyond the traditional ten-year term. Meanwhile, the President's economic message shifted the focus away from defining simple growth targets to improving the quality of growth. One part of that includes the reform of state-owned enterprises, but not simple privatization. Rather, the emphasis will be on turning these enterprises into "world-class, globally competitive firms.” Another aspect is a stronger focus on the environment, where China strives for global leadership. The economic agenda shows that leadership understands the importance of addressing the overly in debt state-owned enterprise sector and the environmental side effects of the past fast-growth strategy, even if the price is weaker headline gross domestic product (GDP).  

Politics aren’t much of a risk in Japan

Incumbent Japanese Prime Minister Shinzo Abe won the snap lower house elections he called for in late October. His coalition already had a comfortable majority in both Diet chambers, but the election provided Abe with a new mandate to pursue some of his more controversial policies. A more aggressive foreign policy is one, which may require a change of Japan's pacifist post-war constitution. The implications for economic policy are more minor. Growth has improved over the past 12 months, Japan's unemployment rate has fallen below 3%, and corporate profits are growing robustly. What is still missing is faster wage growth, a necessary condition to finally lift inflation above 0% and eventually allow for a normalization of monetary policy. Abe's victory also keeps alive his plan to raise the consumption tax for a second time in 2019. The last time the government raised the tax, in 2014, Japan plunged back into recession, and it took two years for the economy to recover. Let's hope the government learned from that experience.      

The global expansion marches on

Global economic growth should accelerate further in the second half of 2017. So far, third quarter GDP reports have shown generally stronger growth in Europe and Asia. Political events may have the potential to disrupt the global expansion. Still, fundamentals and expansionary monetary policy are powerful market drivers that need more than merely an election surprise to knock them off course.