What impact will politics have on markets?
Cazenove Capital's Chief Investment Officer Caspar Rock suggests that over the long term, economic fundamentals drive returns. But politics influence the direction of economic travel and can be a source of short-term volatility.
Even if the UK election goes exactly as predicted by polls, elections around the world have already provided a few surprises this year. Voters in Mexico delivered a far larger majority for the incumbent party than expected, while in India Narendra Modi won a lower share of the vote than projected by polls. France called a shock parliamentary election following disappointment for the ruling party in the European Parliament election. All of this comes before perhaps the most consequential vote for markets, the US election in November. Polling puts Trump very slightly ahead, but the outcome is still up for grabs. It is also still possible that one or both of the candidates changes.
Economics in the driving seat for now
Some of these developments have had an impact in local markets. Indian equities (now the fourth largest stock market in the world) fell 6% following the underwhelming result for Modi’s Bharatiya Janata Party, though they have since rebounded strongly. French equities and bonds declined as investors priced in the risk of a shift towards more populist policies. However, global markets have primarily been driven by economic developments, with growth stronger and inflation higher than expected at the start of the year.
There have been some signs that high interest rates are weighing on activity. US unemployment is still low by historical standards, but the rate has edged back up to 4% for the first time since late 2021. However, the general picture remains one of economic resilience. Schroders’ economists have been nudging up growth forecasts for 2024 and 2025 across the major economic regions. This is one reason why inflation is proving “sticky”. The most widely followed measure of US inflation fell from 9% to 3% over the course of a year (mid-2022 to mid-2023). Progress towards the Fed’s 2% target since then has been slow, delaying hoped-for interest rate cuts in the US.
These trends have provided a solid backdrop for equity markets, and a less supportive one for bonds. The MSCI All Countries World Index is up by around 10% as of mid- June, including dividends. Taking income into account, bonds have just about eked out a positive return.
One striking feature of today’s equity markets is how much more relaxed they have become about the outlook for interest rates. For much of 2022 and 2023, they would rise and fall in response to every piece of data that shed light on central bankers’ intentions.
It’s not just a question of sentiment. Big economies have also shown they can handle higher rates far better than economists anticipated. One key reason for this is that businesses and households locked in long-term borrowing at very low rates in 2020 and 2021 and are now able to put excess cash on deposit at higher rates than their cost of debt. So some are actually better off with higher interest rates. Along with other factors, this has meant it has taken longer for rate increases to have an impact.
Mixed messages from central banks
This is consistent with Schroders’ long-term framework – the 3ds of deglobalisation, decarbonisation and demographics – which suggests that inflation will remain slightly higher and more volatile than we are used to. As a consequence, the path to lower interest rates may not be steady or fast. This could cause volatility if market expectations deviate too much from those of central bankers.
Investors appear to have concluded that the direction of interest rates is more important than the precise timing of cuts. More and more central banks are now lowering rates: Switzerland, Sweden, Canada and the Eurozone have all reduced interest rates in recent months. In most of these cases, inflation is not yet back at target, but policymakers believe it is heading in that direction, justifying a shift towards easier monetary policy.
There’s still some nervousness though, and European Central Bank (ECB) officials have been at pains to point out that further rate cuts should not be taken for granted. Indeed, the day before its decision, data suggested that Eurozone inflation rose very slightly in May. While central banks are just about confident enough to begin the process of lowering rates, they are still worried about inflation (especially in services sectors) and wary of suggesting that rates will be cut quickly.
Investors can’t afford to ignore politics
If Donald Trump wins the US election, it will not be the first time that a president has been elected to non-consecutive terms. He would share the honour with Grover Cleveland, who served two non-consecutive terms in the late nineteenth century. However, Trump would be the first president with a criminal conviction. So far, there has not been much reaction in either markets or the polls to the guilty verdict, though this could still change after the first presidential debate in late June or when Trump is sentenced in mid-July.
How is it that markets haven’t reacted more to the political changes that this year could bring? In the case of the US, it may be that the election is still too far away and the candidates’ plans too vague. In the UK, it perhaps reflects election campaigns that have engaged in a “conspiracy of silence”, as the Institute for Fiscal Studies put it, over the UK’s key challenges.
There’s also the market’s fascination with AI and technology, which may turn out to be a more enduring trend than any political shift. Microsoft, Apple and Nvidia are now each worth around $3 trillion, roughly the same size as both the UK’s annual economic output and its stock market capitalisation. Tweaks to UK taxation may simply not be that meaningful to institutional investors with a global perspective. This may no longer just be an issue for the UK: the US tech giants are now worth far more than the US government’s annual tax base of $4.4 trillion in 2023.
While these companies have huge resources and influence, the fact is they don’t operate in a political vacuum. Further regulation of AI is likely. And you don’t have to look very far to see just how much economic impact politics can have. As a new UK government looks set to take office, the experience of autumn 2022 remains a clear warning of the dangers of losing the confidence of the markets, echoed in the reaction to the snap French election. On the other hand, political initiatives can also create huge new opportunities for investors, such as the significant US spending commitments on infrastructure and clean energy over the next few years.
At some point, the political systems in developed markets will have to decide how to allocate limited resources to address significant, long-term challenges. In both the US and UK, government debt is already at very high levels, while ageing populations are placing ever greater burdens on the state. There will also be difficult choices to make around climate change and defence. The challenge for politicians will be finding the right balance between tax, spending and debt, while keeping markets and voters onside. There will inevitably be investment implications.
For the time being, financial markets are performing well thanks to broadly supportive growth and inflation. We could well make it through the coming year without any hard political choices that interfere with this picture. However, the costs of inaction can also be high. The IMF often plays the role of a doom-monger on economics. But as elections approach, its recent warning about the wrong choices leading to a period of sluggish growth and discontent – the “Tepid Twenties” – is particularly resonant.
ENDS
For further information, please contact:
Estelle Bibby
Head of Marketing and Communications
+44 20 7658 3431
estelle.bibby@CazenoveCapital.com
Nicholas Paisner
Head of Editorial
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