Blame Populism

by: The Heisenberg


Over the past several years, analysts have variously attempted to communicate the extent to which the epochal political shift in Western democracies would eventually bode ill for markets.

This week, one bank was out explicitly blaming populism for many of 2018's market shocks.

While the wording was strong, the concept is hardly new.

As Ray Dalio put it last year, "Populism scares me."

After all, populism, protectionism and deficit spending are all inflationary.

That's from Deutsche Bank's Aleksandar Kocic, one of my favorite strategists on Wall Street, and it's excerpted from a note published in July 2017.

Over the past three years, analysts have been at pains to find creative ways to convey a relatively straightforward point about the implications for markets of the political shift in Western democracies. A combination of factors including, but by no means limited to, rising inequality, stagnant wages for large swaths of middle-class workers in developed economies and the perception that mass migration portends dangerous culture clashes, has strengthened the appeal of populist politics and candidates.

Some of the grievances that have found expression through the political platforms of Donald Trump (in America), Marine Le Pen (in France), Matteo Salvini (in Italy) and the "Brexiteers" (in the U.K.) have merit and are legitimate. Other complaints are based on irrational fears and are meritless.

That is not an attempt to malign populism. Every political party and every political movement seeks to address a set of grievances harbored by its members and adherents, respectively, and it is everywhere and always the case that some of those grievances have more merit than others. The problem for investors in a world where populism is ascendant is that generally speaking, populism produces unfavorable outcomes sooner or later.

Again, that's not an attempt to malign populism; it's just an appeal to historical precedent. If you're interested in a lengthy treatment of this in the context of markets and economics, Ray Dalio (who famously remarked that populism "scares" him) and Bridgewater posted a publicly available study last year that is well worth your time. You can find the .pdf here. Here's a quick excerpt from the introduction that gives you an idea of where we stand on this relative to (fairly) recent history:

To help get a sense of how the level of populist support today compares to populism in the past, we created an index of the share of votes received by populist/anti-establishment parties or candidates in national elections, for all the major developed countries (covering the US, UK, Japan, Germany, France, Italy, and Spain) all the way back to 1900, weighting the countries by their population shares. We sought to identify parties/candidates who made attacking the political/corporate establishment their key political cause. Obviously, the exercise is inherently rough, so don’t squint too much at particular wiggles. But the broad trends are clear. Populism has surged in recent years and is currently at its highest level since the late 1930s (though the ideology of the populists today is much less extreme compared to the 1930s).

As Bridgewater notes, the latest point on that chart "includes cases like Trump, UKIP in the UK, AfD in Germany, National Front in France, Podemos in Spain, and the Five Star Movement in Italy."

Obviously, going back in time and detailing all of the multifarious ways this has gone wrong is well beyond the scope of anything that's amenable to this platform, so let me just skip straight to the following quote from a BofAML note out on Wednesday:

2018 has undoubtedly had its fair share of left-field events. In fact, it’s felt like a non-stop event risk roller coaster this year: “Vixplosion” in February, US LIBOR surging in March, inflation worries in April, Italy and EM pressure in May and trade fears in June (Chart 1). And while these appear like a series of disconnected shocks, a common thread to some of them is that they are a consequence of populism: the protectionist, antagonistic and deglobalization lurch by western leaders.

Before I go any further, let me just go ahead and answer the question that some readers are undoubtedly asking themselves after reading that quote from BofAML: "How can you attribute all of the events in that chart to populism?"

Well, quite easily, actually. The dollar funding squeeze that played out in Q1 (see chart below) was precipitated by the knock-on effects of the tax cuts and the spending bill (e.g., repatriation effects and T-bill supply), which are part and parcel of Trump's populist fiscal policy.

(Source: Goldman)

The VIX spike came on Monday, February 5, and it was preceded by an above-consensus average hourly earnings print which stoked an inflation scare. One of the main reasons markets are so concerned about inflation is down to the assumption that the Fed will lean more hawkish than they otherwise might, in an effort to get out ahead of a scenario where late-cycle fiscal stimulus causes the Phillips curve to snap back to life and steepen dramatically. There's also evidence to support the contention that tariffs and a rolling back of globalization will steepen the Phillips curve (see charts below).

(Source: Barclays)

The slide in the Turkish lira is a clear consequence of President Recep Tayyip Erdogan's populist policies with regard to the Turkish economy, and the dramatic selloff in Italian bonds came amid extreme consternation about the future of Italy's fiscal position as Five Star and League formed a populist coalition government (the chart below shows the one-day rise, in basis points, of yields on 2-year Italian bonds that occurred on May 29 at the height of the political turmoil).

(Sources: Heisenberg, Bloomberg)

You could (and should) take this further.

For instance, the fiscal stimulus push in the U.S. is coinciding with the Fed's efforts to run down the balance sheet. In the simplest possible terms, there's more supply as Treasury borrows to fund the tax cuts and higher spending. At the same time, the Fed is pulling its support for the market. The burden thus falls on private investors to take up the slack and absorb all of that new supply, and that, in turn, sucks liquidity out of the rest of the dollar bond market. That latter point is a big deal for emerging markets, and it's why the RBI's Urjit Patel penned an op-ed published in the Financial Times early last month, imploring the Fed to calibrate the pace of balance sheet normalization to account for the increased Treasury supply. In that way, populist fiscal policy is serving to undermine emerging markets.

And then there's protectionism. The burgeoning global trade war threatens to undercut global growth and risks across-the-board demand destruction in a worst-case scenario. The fear of just that catalyzed the worst day for commodities since 2014 on Wednesday.

While a slowdown in global growth and falling commodity prices have the potential to create deflationary outcomes, the near-term outlook for a world governed by trade restrictions and tariffs is inflationary, for obvious reasons. Consider this, from a SocGen note dated Thursday:

As of late, the deflationary impact of the trade war has been dominating. The escalating tariffs war between the US and the rest of the world is disrupting global supply chains and increasing the cost of imported goods in the short term. However, it could also spell the end of the reflation story that has supported the markets since February 2016. In fact, the global growth re-synchronisation story, driven by the recovery of Europe in 2017, has already been delayed. The decoupling of growth stories is clearly visible in the degree of underperformance of EM equities (impacted by strong outflows from EM assets) versus Nasdaq 100, both of which are generally used to leverage growth expectations. Concerns over the growth outlook are also reflected in the outperformance of long-duration sectors (defensive) versus short-duration sectors (cyclical) across the board.

And here's how I put it on Wednesday:

When combined with the possible inflationary effects of tariffs, deflationary outcomes send ambiguous signals and make it difficult for policymakers to figure out how to respond. Throw in the surging dollar and you've got a real conundrum.

More broadly though (and this gets back to BofAML's point), the antagonistic approach to globalization and the multilateral institutions that are part and parcel of the post-War order is extremely concerning for market participants.

Globalization in all its various manifestations has become a casualty of the epochal political shift. It (globalization) has become a kind of catch-all concept that gets tossed about haphazardly to "explain" everything from stagnant middle-class wages in developed markets to the offshoring of jobs. Because "globalization" is a concept and thus not entirely tangible, multilateral institutions are targeted and painted as the conduits through which deleterious dynamics are channeled.

While that plays well on the campaign trail, it is extremely disconcerting for stewards of capital and really for anyone who has, for decades, invested based on the previously safe assumption that the scaffolding of global trade, commerce and cooperation more generally wouldn't be upended virtually overnight with market consequences and economic outcomes that are by definition impossible to predict ahead of time.

In that context, consider this passage from a note penned by BNP's Chief Market Economist and Head of US Economics, Paul Mortimer-Lee, last month:

One remarkable thing to note is that the dissonance in western international relations has emerged when economic times are relatively good, when unemployment is low and inflation is under control. This gives us real pause for thought about what might happen when the next downturn comes and unemployment starts to rise. Things could get really nasty and populism could ratchet up sharply.

There's a ton more on that in a lengthy piece called "Sunset" I penned several weeks ago, but I think that short excerpt gets the point across.

The fear of the unknown is part of what derailed the global risk rally in 2018. While U.S. benchmarks have done a truly admirable job of trudging higher in the face of a dizzying array of negative geopolitical headlines, it's worth noting that the resilience of U.S. equities relative to the rest of the world is down to earnings growth, buybacks and the prospect of fiscal stimulus prolonging what is already the second-longest expansion in U.S. history.

All of those pillars (strong earnings growth, the buyback bonanza and the strong U.S. economy) are manifestations of the Trump administration's populist fiscal policies.

In the most recent edition of their quarterly global macro survey (which represents the opinions of 400 institutional investor clients), Barclays described an "enthusiasm for all things American." Here's a visual from the survey:

(Source: Barclays)

In a testament to the worrying dynamic playing out behind the scenes, the same survey betrayed a significant shift in respondents' opinions on where the next downside shock to global growth might emanate from. While worries about a Chinese hard landing have abated somewhat, there was still palpable concern for China, and it was coupled with a sharp increase in the number of respondents (from Q1 to Q2) who are now concerned about emerging markets as a whole and also Europe:

(Source: Barclays)

All of this points in the same direction. That is, it all suggests that investors are becoming increasingly concerned that the epochal political shift that's unfolded across Western democracies over the past several years threatens to force a complete strategic rethink in order to align investment objectives with a new reality. The problem is, no one knows what that new reality is going to look like.

What I would encourage you to consider is that very much contrary to what you might have heard, the old reality was leading to increasingly favorable outcomes for more and more people. Consider this quote from an interview Jerome Powell did with American Public Media’s “Marketplace” program (published on Thursday):

The truth is this: Since War II we’ve had this trading system develop, and consistently tariffs have come down and trade has grown. And I think that’s served the global economy, and particularly the United States economy, very well. It drives productivity. It’s driven incomes up but it doesn’t help everyone. There are there are always particular groups of people, particular populations and geographies that are that are negatively affected by trading and the country hasn’t done, no country has really done a good job of addressing those concerns. We need to do that.

Part of that is ambiguous. That is, it's not clear what "that" is which "needs" to be "done." What is unambiguous is the first part of that statement, where Powell says that the global economy has benefited from globalization.

The bottom line for investors here is that until such a time as there's some resolution to all of this (and that seems like it's a long ways off), we've likely entered a new regime.

And on that note, I'll leave you with one last quote from the same BofAML note cited above, in which the bank explains what it thinks all of this means and what the new regime for market participants is:

2017 was also fraught with risks - albeit mostly on the election front - and yet the market barely missed a beat last year. For us, the biggest change in market dynamics recently has been that “buy the dip” behavior has morphed into a “sell the dip” mindset, leaving markets much more fragile.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.