Politics’ impact on markets – like people – is unpredictable

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October 11, 2017

Does politics matter to investors? Read any market report and the answer might seem obvious. Market movements are often explained as reactions to an unfolding political story – Brexit, Catalonia, North Korea, Donald Trump, European elections. All of these have at times, over the last 18 months, seemed to be key market drivers – but the reality is more nuanced.

These five political stories have influenced financial markets in quite different ways, from which investors can draw a range of conclusions.

Brexit is the longest-running of the five and to UK investors probably seems the most important. The distinguishing feature of this story is that, unlike some, if not all, of the others, it is having a real economic impact. In the last week, we have seen how the stalling negotiations with the rest of the European Union (EU), and the associated Westminster psychodrama, is dragging the UK economy down. A near 10 per cent fall in car sales in the key month of September, dismal construction sector data and a slide from the top to the bottom of the G7 growth league are starting to look like worrying trends.

What is interesting from an investment perspective, however, is that investors have largely shrugged off this relentless flow of bad news. The FTSE 100 stood at about 6000 in June 2016. Today, it is close to a record high above 7500. The reason, of course, is that Brexit uncertainty and a rudderless government have hit the value of the pound. And for a market dominated by exporters and overseas earners, that has been a positive for sterling-based investors.

Over in Europe, politics has been influential in a quite different way. A year ago, the prospect of a packed electoral calendar across the region cast a long shadow over markets. Britain’s vote to leave the EU and the election of President Trump in the US seemed to point to a turning of the tide towards right-wing populism. Concern about victories for nationalist parties in Holland and France, if not in Germany, ensured that market sentiment was weak as 2017 began.

The reality was more benign. Pragmatism and common sense prevailed in all the key elections and investors have been able to focus on Europe’s rapidly improving economy, its supportive central bank and its rising corporate earnings. So in Europe, the key effect of politics until recently was to unnecessarily dampen sentiment and create investment opportunities. Germany’s DAX index is up more than 20 per cent over the last year; Italy’s sharemarket is more than a third higher.

The market reaction to Catalonia’s bid for independence has highlighted how dramatic political events can have an outsized influence on investors. The slide in Spanish shares last week was the biggest in 15 months and outflows from Spanish funds were the greatest since an earlier independence poll in 2014. Madrid’s Ibex 35 Index has fallen by 10 per cent since a high in May, a technical market correction and completely against the tide of European markets as a whole.

Catalonia accounts for a significant proportion of the Spanish economy so the potential for disruption should not be dismissed. But given how much easier it will be for the region to declare independence than to deliver it, with no obvious support for secession from the international community and Madrid’s determination to block it, the market reaction may well turn out to be too much, too soon. Investors appear to have overreacted to the political drama and focused too little on the real economic impact.

Turn to North Korea and the market reaction has been just as puzzling – in the opposite direction. When you consider the worst-case scenario, investors’ response to Kim Jong-Un’s sabre-rattling looks complacent. Indeed, the market most obviously at risk from an escalation of the Kim-Trump stand-off has seemingly welcomed the crisis. The Kospi Index in Seoul stands 20 per cent higher than a year ago and it has been positively correlated to the intensification of Kim’s nuclear rhetoric. The more missiles he has fired, the higher the Kospi has risen.

This makes more sense than might appear. Again, it is about probabilities. The market has taken the view, probably rightly, that a nuclear conflagration is unlikely. More likely is that this turns out to be a storm in a teacup. The crisis will pass and South Korea will be seen again as one of the biggest beneficiaries of the ongoing uptick in global economic activity.

That leaves Trump, specifically his proposed tax reforms. From a market perspective, this has been the most important political influence in recent weeks, driving Wall Street to a record-breaking run of new record highs. Like the Catalonia situation, this looks to be an over-reaction, this time a positive one.

The market has latched onto the White House’s tax reform proposals, seeing them as the key to re-starting the stalled Trump Trade that galvanised Wall Street in the wake of the presidential election last year. In doing so, it seems to have fallen into the trap of wishful thinking. Hoping that something will happen is a poor substitute for a careful analysis of whether it is likely to do so. Rather, this looks like an ex-post rationalisation of a late-cycle market rally. (Shares are going up; how can we explain this?)

So the short answer to my opening question is that politics does matter to investors but in unpredictable and often contradictory ways. Investors over- and under-react to political developments. The economic impact is more important than the political headline but this is often hard to fathom at the time and may change (as with the fading of the post-Brexit honeymoon period).

What is clear, however, is that for the alert investor, politically driven shifts in sentiment can create great opportunities.


TOPICS:   Brexit,  Catalonia,  Donald Trump,  Europe,  geopolitical risk,  geopolitics,  news analysis,  North Korea