Politics and markets

Uncertainty and disruption are associated with political events. At the extreme end, prices and trade can be impacted – both of which can have global implications. More locally, shifts in political priorities will play out but don’t necessarily have big or long-lasting negative effects on markets. As the UK sets out with a new government, the omens are positive for market returns. Across the channel, there is more uncertainty. UK equity underperformance since the 2016 Brexit vote might continue to reverse.

Clear result: Markets up – A clear change in the political complexion of government and/or the achievement of a sizeable majority in parliament have tended to be the conditions necessary for a positive response from UK financial markets. The general election’s results satisfy both. As a result, I would expect UK equity markets to perform well and the gilt market to rally, based on both a lower political risk premium and the prospect of Bank of England interest rate cuts. The last time Labour took office after an extended period in opposition and achieved a sizeable majority of seats was in 1997. A month after the election, the FTSE 100 was 4% higher and gilt yields were 22 basis points (bp) lower. A year on and the FTSE 100 was up over 35% and gilt yields were 160bp lower.

Positive on balance – Of course, superior UK financial asset returns are not guaranteed but there are favourable tailwinds. The election removes from office a government tainted by the turmoil of Brexit and multiple leadership changes, as well as negative optics over behaviour. Politicians underestimate how that reflects on a country in the eyes of international investors. In addition, the UK equity market is cheap relative to its peers and so is the currency. As such, it is ripe for global buyers. On the macro front, we see growth rising from the 0.3% year-on-year rate registered in the first quarter to somewhere between 1.0% and 1.5% in 2025. There are upside risks to that, especially if monetary policy is eased. On the fiscal side, the outlook is not great but the UK is in no worse a position than many European peers and the US. There is no reason gilts should underperform other developed sovereign bonds.

Details – Labour’s manifesto was characteristically short on detail. It says it will prioritise growth and any budgetary ambitions will be fully funded. There are promises to reform the energy sector and improve infrastructure by extending state ownership of the railways, modernising ports and prioritising road building. There may have been some lessons learned from the US as well, given the focus on green energy as part of a broader industrial policy. All of these are geared towards “kick-starting growth” as the manifesto claims. A better relationship with Europe is promised, although this falls short of any kind of commitment to rejoin the Single Market or the Customs Union.

Adaption – The British economy in general, as well as the City of London, have had to adapt to a post-Brexit world. A lot of euro-denominated trading and investment business had to be relocated to centres within the European Union, meaning London lost many European finance professionals. For a time, Paris overtook London as the major centre for equity trading. It will be interesting to see what happens going forward and whether London’s historical competitive advantages can again support robust growth in a vital sector to the UK economy. Banking, asset management and insurance will continue to be important but there is also scope for fintech and crypto businesses to flourish in a more stable political environment.

Risk abroad – So for UK assets, yesterday’s outcome might have reduced localised political risks. Outside the UK, however, this is not the case. I write just before French voters head to the polls for the second time, to finalise what the National Assembly will look like following President Emmanuel Macron’s announcement to dissolve it a few weeks ago. In the US, there is uncertainty about whether President Joe Biden will be the Democratic candidate in November given concerns about his health. Globally, the risk of conflict escalation in both Ukraine and the Middle East remains high. Structurally, polarisation of western and non-western cultures and political ambitions will shape our history in the coming decades - with implications for military spending, physical and cyber security, immigration management and, of course, climate change risks.

Assessing pol-risk – As such investors will constantly be reminded about political risk. It is easy to talk about that but not so easy to define it and be precise about how the presence of political risk impacts portfolios. But there are some obvious channels. The first is uncertainty. Political upheaval like unexpected election results or, in more extreme cases, rapid government change, creates uncertainty around policy and the economic outlook. That cuts across several dimensions – what happens to growth and inflation? How will monetary policy be managed? Will there be an increase in government borrowing? Will there be a change in foreign relations that impact trade and investment flows? Multiple market reactions are possible, usually focused on the path of rates and the currency of the country in question. For emerging economies, such political uncertainty can risk weaker capital flows which can raise concerns about external financing if foreign exchange reserve levels become depleted. The concern in France at the moment is that an inconclusive result on Sunday will make it hard to make the necessary budgetary adjustments to stabilise its debt-to-GDP ratio. The increase in French bond yields relative to German yields is likely to persist as a result.

France is a clear example of concerns in developed countries typically being around fiscal policy and debt sustainability. Given the consistent increase in government debt-to-GDP levels in recent years, degrees of freedom for governments are limited before they generate adverse market reactions (higher bond yields). Other concerns will be about the credibility of growth plans, industrial and trade policies, and regulation. Political uncertainty generates policy uncertainty, therefore making it difficult for investors to have confidence in investment returns. That may lead to more defensive capital allocations and higher risk premiums.

France and the US have this kind of uncertainty now because we do not yet know what their respective governments will look like after the upcoming elections. The UK is better placed in this regard even if there are gaps in the detail of the Labour Party’s manifesto.

Disruption – On the global scene, geopolitical risks impact markets through potential consequences for demand and supply channels. Events such as terrorist attacks (or the threat of them), heightened military tensions or outright conflict impact consumer and business spending in the regions affected. Movement of people (travel), goods and capital flows can be affected negatively. Market access for imports and exports will also suffer. Investments in firms engaged in activity directly or indirectly with countries and regions suffering geopolitical conflict will become riskier. As we saw in 2023, a geopolitical event can create a supply shock and lead to inflation, which in turn means higher interest rates and adverse growth and investment implications. If Russia had not invaded Ukraine, there would not have been such an energy price shock, rates might not have gone up as much, bond returns would have been less negative and growth in Europe might have been stronger.

Macro impact – That geopolitical event did impact on spending and investment decisions as businesses and consumers became risk averse. The macro risk materialised. It was negative for growth and did lead to higher risk premiums (lower prices) in equity and credit. However, investors can take comfort in the fact that, often, markets overreact to geopolitical events. Initial responses create buying opportunities and the reach of disruption is often less than feared. As the old saying goes, there is nothing to fear but fear itself.

The biggest fear today is of a new global conflict between the West and an alliance of China, Russia, India, and others of the Global South. That is a tail risk that could impact on global capital allocation (deglobalisation) and adaptions to supply chains. Tensions exist and have become more tangible in recent years, and the potential re-election of Donald Trump in the US could intensify them. But here we are with equities at record highs and real bond yields stable to moving lower. In the short-term, trade the economics not the politics.

Round two – There will be time to assess what happens in the US later this year, depending on whether the Democrats do replace Biden or not. There is more talk of ‘Trump wins’ trades – which are a little bearish for Treasuries (fiscal expansion and inflation), bullish for the dollar and may lean a little against the technology bubble. But they are not impacting pricing right now. Indeed, the bond market is more focused on the timing of a Federal Reserve easing as the data flow weakens (July rate cut a potential surprise?), and equity markets remain fuelled by the concentrated artificial intelligence-driven frenzy. So far, volatility has remained quite low (the VIX is at 12), and everyone is pointing to July being, historically, a favourable month for bond and equity returns. The last semester of 2024 might not be so calm.

(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 4 July 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.