You could argue that ever since the fall of the Berlin Wall, markets have become quite blasé about politics.
The free market had won. History had ended. With a few small exceptions, the world had embraced capitalism and it was really just a matter of time before most countries’ economies basically looked the same. The eurozone may have been the most obvious manifestation of this belief system.
And I can’t begin to count the number of stories I’d read in that period where political paralysis or gridlock in one country or other was viewed as a boon rather than a problem. While politicians were just arguing with one another, the market was able to “get on with it”.
That’s not the case anymore. From Brexit to Trump-mania, investors are having to pay very close attention to politics once again.
In fact, according to Bank of America Merrill Lynch, politics could be the key to the next big turning point in global markets…
Central bankers have been losing the war on deflation
As analysts at Bank of America Merrill Lynch (BAML) point out: “since the global financial crisis, the ‘war on deflation’ has been fought exclusively with monetary policy”. And we haven’t really got anywhere.
That might make it sound as though central banks haven’t done much. They have. Interest rates are at their lowest levels ever (in 5,000 years, to be exact, according to some – although I suspect the data gets a bit shaky more than a few millennia back).
Since Lehman Brothers went bust, there have been 654 rate cuts globally. Central banks’ balance sheets have expanded to the point where they are larger than the GDP of the US and Japan combined. And roughly $10trn of global bonds trade on negative yields (in other words, investors are technically paying – in nominal terms – for the privilege of holding them).
Yet despite all this “stimulus”, global growth and inflation remain feeble by historic standards; debt levels are at peacetime records, making companies and consumers cautious; and various forces – technological innovation being the main one – are forcing down prices across many industries.
There are plenty of interesting charts in the report. But BAML highlights two particularly fascinating ones. Firstly, relative to the rest of the US market, bank stocks are near their lowest in 75 years. Indeed, note the analysts, “the chart of relative bank performance could easily be mistaken for a chart of interest rates”. That’s no coincidence. Low rates make it difficult for banks to turn a profit.
Secondly, the ten-year rolling annualised return from commodities is at its lowest level since just after the Depression era. Deflation has hammered the asset class.
From a contrarian point of view, the implications are obvious. Global markets are pricing in a world without inflation, a world with chronic, secular stagnation – a world that looks a lot like Japan has over the last 20-odd years. That’s what prices are telling us and it’s also what all the mainstream pundits are most exercised about.
It shows all the signs of a bubble. Extremes in pricing, and a catchy narrative. Trouble is, what would pop this bubble, and turn it around?
When voters get fed up, they can change markets
Oddly enough, you can look to Japan for a hint as to the answer here.
The Japanese finally got fed up with the way things were back in 2012. They voted in Shinzo Abe. The previous year, the Japanese yen had hit its strongest level against the dollar on record (around 75 yen to the dollar).
Abe was elected on a platform of using central bank policies to weaken the currency, and somehow inject inflation back into the system. The yen rapidly lost value. Of course, Abe is still looking for his inflation. But the point is – when people get fed up, they vote for change. That can have a huge impact on prices.
And this is what BAML reckons will result in the next big shift – angry voters, waging a “War on Inequality”. “Electorates are increasingly voting for policies to address wage deflation, unemployment, immigration and inequality.”
We’ve said for a while here at MoneyWeek that rising populism is a direct result of politicians dumping responsibility for tackling difficult economic problems on central bankers. I’m not suggesting that we should all get out our violins for the central bankers of the world. But there really is only so much that they can do.
Making the decision to keep interest rates ultra-low and to print money to prevent mass runs on the global financial system was a tricky hurdle to jump in the first place, but the choice there was much clearer. A big part of me would still rather that the banks had gone bust and creative destruction had ensued, but if you had held a referendum on the topic, I suspect I’d have been in the minority.
But central banks’ decisions have become increasingly politically challenging. They’re already picking winners and losers, and they know it. Low interest rates take from one constituency (savers) and give to another (debtors and asset owners). Those who own property benefit at the expense of those who don’t.
Existing pensioners do just fine, protected by the “triple lock” and the remnants of the final salary scheme days. But future pensioners – wondering how on earth they can save enough to generate an income for their golden years, given low interest rates – are left adrift.
This all creates a perception that society is unfair. And if there’s one thing that human beings can’t stand, it’s a sense that the world is treating them unfairly. Hence the rise in protest politics, from Nigel Farage to Jeremy Corbyn to Donald Trump. People are unhappy with the way things are, and they want change.
Some of those grievances are justified. Some of them are misplaced – on measures of income, particularly post-tax income, inequality in the UK just isn’t noticeably worse than it has been historically. And some of the “solutions” would be far worse than the current situation.
But none of that is the point. The current crop of politicians got us here by dodging tough choices (such as genuine financial sector reform) and leaving it to central banks in the hope that time and low rates would somehow return things to the way they were.
That hasn’t happened. Now the old regimes are in the firing line. As a result, BAML suggests a swathe of political policies – from helicopter money (where money printing is directed by government) to much higher taxes to protectionist policies (which includes anti-immigration policies) – could finally trigger inflation, and potentially “mark a historical inflection point for inflation and bond yields”.
So what should we watch out for? It’s worth understanding that this doesn’t have to be about Trump winning, or voters backing Brexit, or sweeping Corbyn to victory at the next election in the UK. The very existence of all of these things drags the conversation in a certain direction.
Trump changes the way that Hillary Clinton campaigns. He changes the promises that she makes. Politicians – the ones who get anywhere – ultimately want power. They promise what it takes to get hold of that power. So if a big group of voters look as though they want something really badly, politicians will humour them.
Protectionist policies. Capital controls. Wealth taxes. Helicopter money. Sooner or later – probably sooner, particularly in the case of Japan – we’re going to see one or all of these being implemented.
Will it be enough to drive that big “secular” shift? Well, if it isn’t, you can expect them to do it until it does.