View from the Bond Market

One of the core themes of populism is taking back control of economic relationships for the benefit of “ordinary” people.

That can mean changing the balance of trade relationships, withdrawing from supra- and multi-national organisations, dismantling regulation that is seen to benefit the “elite” and potentially using monetary policy for blatant domestic reasons. Its appeal is to undo the relationships that have defined the world economic order over the last several decades, the faults of which were laid bare by the great financial crisis. So don’t look at European elections, “Trumpisms” and the unfolding of “Brexit” as mere “political risks”. This is a new era and policy will reflect it. There are profound implications for growth, interest rates and businesses.

There has been an upsurge in interest in the upcoming French presidential election, reflected in the bond market by a significant underperformance of French government bonds relative to other European assets. The key measure is the yield spread relative to German government bonds. At the 10-year benchmark level this spread between French and German paper reached 75 basis points (bps) this week from around 50bps at the end of 2016 and below 30bps during the period between the UK referendum and the US elections. To put it into context, during the European sovereign crisis in 2011-2012 this spread reached 140bps so we are not quite in unchartered waters. However, there is a risk that the French market continues to underperform given the less than clear path towards a new President emerging in May. Since the beginning of the year, the French government bond index has underperformed the German equivalent by 2%.

The rise of populism
Investor concern is around the uncertain political outcome. There are good reasons to be concerned given the steady polling numbers of the Front National (FN) candidate, Marine Le Pen, and the lack of a clear frontrunner from the mainstream of French politics. The political shocks of 2016 are still very raw and the French election is cast in the context of the global rise of nationalistic populismthat many see already having propelled the UK electorate to vote to leave the European Union (EU) and the US to elect Donald Trump to the Presidency. Increasingly I am of the view that investors can’t just simply list these events as “political risk” that introduce some isolated temporary volatility into markets. Instead we should be thinking about the deeper, longer-term implications of a secular shift in the political landscape that has implications for policy, economic growth, inflation and global trade flows. In order to do this, we need a framework for thinking about what is behind the rise in populism and what are the most likely economic and market implications of the policy agenda that is going to be impacted by this political trend. I read a very interesting and helpful paper from the Harvard – John F. Kennedy School of Government (1) to try and get some clear thinking on this issue. It describes populism as a loose set of ideas that has a core of anti-establishment, authoritarian and nativist themes. There is a dis-trust of “elites”, a reaction against big business and big government, and is generally against internationalism. The literature identifies two broad reasons that help to explain the rise in support for populist parties – economic insecurity and inequality that is seen to be the result of globalisation and technological change, and a cultural backlash against progressive ideas associated with cosmopolitan liberalism (including free movement of people, multiculturalism and acceptance of liberal social values). The paper goes on to cite research into various demographic, geographical and educational characteristics that help explain support for populist political parties and leaders.

Home rule
The socio-political aspects of all of this are fascinating in themselves but for investors the key is to try to understand what are the economic and market implications. Now it may be that the scope for overtly populist parties to assume power in a large number of countries is limited but it is still useful to think of the “agenda” being influenced by the rise of populist rhetoric. Even with mainstream parties in power, the policy agenda might reflect some of these broader themes. There are some general characteristics of populism – Nativism tends to bias towards trade protectionism, national preferences in consumption and investment (“buy American”, pressures on companies not to locate production abroad, capital repatriation), potentially competitive exchange rate policies, restrictions on the free movement of labour and prioritising national defence rather than contributing to multi-national peacekeeping. Domestically the focus is job creation for “nationals”, driven by growth supportive macro policies such as tax cuts and spending on infrastructure. There is a focus on domestic growth at the expense of international co-operation as “free trade” is seen to generate more costs (in terms of the loss of well paid jobs and lower living standards) than benefits (or at least the benefits are seen to only accrue to a minority). From a policy perspective one can see populism through the lens of “taking back control” of international arrangements that are seen as detrimental to national interests. There are a number of examples already. Britain exiting the EU in order to “take back control” of borders, regulation and part of its fiscal budget. The US cancelling the Trans-Pacific Partnership (TPP) and talking tough to large trade partners because it argues that current trade arrangements do not benefit American workers. The FN laid out its policy agenda this week which would involve France leaving the euro zone (and the EU) and re-establishing the franc (which it would devalue) as the euro is seen to have been detrimental to France’s economic growth. Controlling immigration is a common theme, backed by the argument that large-scale immigration creates negative budgetary and social costs (and it also, of course, appeals to the cultural aspects of populism as immigration is seen as a threat to cultural hegemony or security, or both).

Trading from the sell side
The problem is adjusting portfolios to reflect these potential themes, especially as the time-frames are not clear. Take Brexit as an example. It remains hard, more than six months after the vote, to clearly construct investment strategies based on how the UK economy will perform over the next few years. The biggest trade has been sterling but that came about because of a miscalculation of the near-term economic outlook by the Bank of England (BoE). How do you trade France today on the risk that Le Pen gets in and dismantles France’s post-war economic arrangements? The only choice is to sell French government bonds and credits and that is what has been happening. If sentiment currently being expressed in France, the Netherlands and elsewhere in Europe raises the prospects of more widely-spread populist policies, there may be a longer-term trend of less cross-border capital flows and bond financing. The internal balance of payments of the euro area are already massively skewed and if the surplus countries reduce their financing of the deficit countries because of euro break-up risks, then spreads could widen aggressively and another sovereign crisis could erupt. This might be self-perpetuating as any break-up of the euro driven by populism would mean devaluations against Germany (the US Administration as accused Germany of having too weak a currency) so it seems to make sense to hold German bunds rather than the bonds of other euro Area countries. This widens the spread and makes sustaining the euro more difficult. Under the risk of such a scenario, Mario Draghi would not be able to taper.

Inflation is a core theme
Thinking about the US provides clearer investment themes. I have been of the view since Trump gave his acceptance speech in the middle of the night after the election that his Administration would be pro-growth, meaning higher rates and inflation. The kind of plan proposed by Le Pen suggests an aggressive fiscal stimulus for France too, funded by an “independent” Banque de France (BdF). Even in countries where there is no direct populist government in place, populist policies might still be employed to prevent electoral defeats – the UK has toyed with fiscal stimulus and there is certainly less austerity in Europe. Increased borrowing and pressure on central banks to keep monetary and exchange rate policy accommodative adds up to higher bond yields and inflationary expectations. At the moment, inflationary expectations are still within the trading range of the last decade, but if we are potentially in a new political paradigm we have to consider outcomes beyond the recent historical experience. Why not inflation at 5%? Owning inflation linked bonds or some kind of inflation protection should certainly be considered.

Lots of potential market moves
Under a scenario of a progression towards more populist policies that favour nationalism over globalisation, that impinge on the independence of central banks and that use fiscal policy more aggressively than in the past to reduce taxes and fund grandiose projects, one should probably consider the following market moves; higher bond yields and steeper yield curves; increased volatility of cross-market spreads with current account countries underperforming surplus countries; exchange rate volatility as competitive devaluations result from a desire to optimise terms of trade under a regime of higher trade tariffs; higher inflation generally; underperformance of multi-nationals relative to domestic champions; underperformance of emerging markets, particularly deficit countries or those where foreign trade is a high percentage of GDP; outperformance of construction related sectors; underperformance of technology especially if there is a resistance to replacement of manual jobs with robots; underperformance of travel related businesses as anti-internationalism takes hold; widening of peripheral European bond spreads; high yield borrowers could be hit by reforms to interest expense deductibility; and so on.

Not clear for bonds
The biggest market moves would come from where there is the largest retrenchment from current economic relationships. The US removing itself from trade agreements is one thing but this could be offset in terms of investment opportunities by stronger domestic economic growth. The UK removing itself from the EU is clearly negative for many businesses, but much depends on how far the UK can retain access to the Single Market, what happens to existing European nationals in the UK and UK citizens in Europe, and the extent to which the UK can fashion a regulatory environment – in financial services for example – that gives it a competitive advantage. If, and it is very unlikely in my view, the FN win in France, then the breaking of existing embedded sovereign, monetary and defense links could be extremely radical. Is there a case for being very bullish on bonds under this radical world view of populism? Well there is of course if we believe that significant policy and institutional adjustments have a negative impact on growth. A global recession spurred by such a jolt to the economic consensus of the last few decades would normally mean lower rates and positive returns from bonds. But post-capitalist populism might not work like that – What about more monetisation to combat a decline in private sector credit growth? What about defaulting on bonds? What about excessive deficit financing? The bond market might not look like a universally great place to preserve wealth.

Long-term trend
The preceding is probably much too alarmist. For one thing we are only seeing very marginal tilts towards a populist majority (or perhaps not even when we consider the total vote in elections and referendums). There is certainly scope for cosmopolitan liberalism to re-assert itself over the policy agenda. Businesses and citizens might well rebel against radically populist actions if it looks like they will have unwanted economic consequences or go too far in upsetting social norms. In the case of France, the FN only appears to have 25% of the vote so if the mainstream can sort itself out in the next few weeks then any talk of France leaving the EU or the euro will likely turn out to have been fanciful. Even in the US, the time scale of trying to implement a radically populist programme is likely to be longer than Trump and his advisors envisaged – We are still waiting for the details of his “phenomenal” tax plan. But at the very least there is a movement away from the policies of the last decade, driven by a feeling that the financial crisis exposed structural weaknesses in the major economies that have not been dealt with. As such the reflationary aspects of populism are already impacting market returns. Inflation linked bond markets have performed well so far in 2017. The US inflation linked market has delivered a total return of 84 bps so far and the sterling market 149bps. Gold prices have rallied since December and equity returns, especially in the US, have been handsome. However, the full effects of a secular swing in the political pendulum will only be seen over the medium term and I believe it is prudent to have in mind some of the consequences of a different policy agenda in the coming years.

Chris Iggo – Chief Investment Officer, Fixed Income – AXA Investment Managers