(Aug 28): Financial markets have been twisting and turning in reaction to political developments in recent times. Just in the past week, the perception of growing disarray in the Trump administration and tensions in the Korean peninsula caused markets to gyrate. Last year, it was Brexit and Trump’s shock election victory. However, an interesting pattern has been evident: While a political shock initially causes huge market moves, these reactions dissipate and a few weeks or months later, it is almost as if not much has happened.
One can also say much of the political turbulence in the past year has left little residual impact on markets. For example, South Korea saw a president unceremoniously turfed out following a huge scandal that also dragged down the country’s largest business group. Another example was the elections in the Netherlands and France, which many had worried about, but these came and went without much trouble.
So, should we just stop worrying about politics and focus on market fundamentals such as earnings outlook and interest rates?
Sadly, there are two reasons why politics is going to matter more. First, there is a greater chance of political disruption with some potentially nasty political turning points that markets have been underestimating. Second, what allowed markets to rebound so easily from political shocks — easy liquidity and low interest rates — is coming to an end.
Why is it we will have more disruptive political surprises?
Markets do not like unpleasant surprises, so it will be political shocks with potentially huge impacts and whose likelihood markets had underappreciated that will cause the greatest damage. There are several reasons why the world is likely to see more such political surprises in the near future.
First, a global political vacuum has emerged because the US is a diminished power. President Donald Trump’s political capital and ability to push through his agenda have taken a hit as a result of self-inflicted gaffes, such as his many contradictory positions on the Charlottesville riot. Worse still, seven months into his presidency, key administration posts in the critical state, defence and Treasury departments remain unfilled — the same problem is evident in other vital agencies such as the National Security Council. The result is that the Trump administration’s positions on many global political, military and economic issues have not been fleshed out clearly, leaving the US as a passive observer of unfolding developments and prone to being taken by surprise. In its current shape, the US is less able to play a stabilising role and, in some cases, could even destabilise global politics.
Second, the world is in a state of disequilibrium for two reasons.
- The world is shifting from the US-dominated system that prevailed from the early 1990s to a more multi-polar one. In particular, China’s rise has reached a tipping point; it is now confident and powerful enough to try to shift global politics and economics in the directions it wants — as seen in its interventions in the South China Sea and the new economic order it is creating with global-scaled institutions it sponsors such as the Asian Infrastructure Investment Bank and the Belt and Road Initiative. This new China is not a status quo power; it seeks changes to the status quo and will do so more insistently as its power and influence grow. The world has yet to evolve new political mechanisms to smoothly incorporate a rising China, so there will be stresses and strains in the future.
- Large swathes of populations in developed economies as well as emerging economies are suffering dislocations, owing to rapid technological or other changes. Inequality is rising as well as a sense that the system is rigged against ordinary folks by vested interests. The causes of this angst are not fully understood and so mainstream political parties have been unable to fashion responses that assuage the public. This is the public mood, which encourages fringe parties with radical agendas and other troublemakers to gain more power and cause political shocks. These developments will carry serious implications with long-lasting effects, so the market’s reactions are likely to be permanent rather than easily reversible.
So, where could the shocks come from?
In a general way, the current situation is a godsend for the US’ rivals, encouraging China or Russia or smaller powers such as North Korea to push the envelope in sensitive areas in the way that North Korea has already done. With the Trump administration’s capacity to anticipate and respond effectively to challenges reduced, it will not surprise us if China or Russia makes a surprise provocative move in a region where they have critical interests. But it could also be troublesome US allies, who might choose this moment to act — for example, Israel may be tempted to ramp up settlement activities or move against Hezbollah in Lebanon.
More specifically, what could upset the equilibrium in Asia? We can think of a few potential flashpoints.
- Sino-Indian tensions are being underestimated. Since mid-June, Chinese and Indian troops have been engaged in a standoff in the Doklam region that is disputed between China and Bhutan. Since Bhutan is effectively an Indian protectorate, this has become a Sino-Indian problem, with Indian troops trying to prevent the Chinese from building a strategic road in disputed territory. Tensions have recently escalated, with the first violent clash between the two Asian giants in more than a decade on Aug 15 — there were minor casualties when both sides pelted each other with stones. This incident occurred at Pangong Lake, which straddles the Kashmir-Tibet border and is several hundred kilometres from the Doklam standoff. China has grown increasingly angered at India’s refusal to back down in Doklam, as seen in this incident and in the increasingly heated rhetoric in the Chinese media. China may feel that it has to do something to shock India into changing its position. Unless diplomacy can forge some kind of compromise soon, it would not surprise us if China undertook some form of limited or localised military action to penalise India.
- North Korean risks have not gone away. While the fiery rhetoric between the two sides has quietened down, the fundamental situation has not changed: North Korea is determined to develop the capacity to credibly threaten continental US with nuclear weapons and the US is equally determined to ensure that that does not happen. But, the US’ options are risky — North Korea can react to any US action by destroying a large part of South Korea’s capital, Seoul, within hours with its massive artillery force, so any US action will be highly risky and almost certainly opposed by South Korea. China, the only country that has some leverage with North Korea, is not willing to risk instability in North Korea through harsh economic or other sanctions. The first implication of this imbroglio has become clearer in recent days. Not satisfied with United Nations sanctions, the US has added its own unilateral sanctions, targeting Chinese and Russian companies it accuses of helping North Korea procure components for its weapons development. US pressure will certainly result in more hostility between the US and China. But it will not end there. The US has to fashion a strategy that successfully stops North Korea’s development of nuclear-armed missiles that can reach any part of the US. If sanctions do not work, it will have to consider more provocative actions such as intrusive checks on ships entering or leaving North Korea or even surgical military action.
- The South China Sea remains a hotspot. Two weeks ago, several Chinese fishing vessels, protected by a Chinese navy ship, descended on the waters surrounding Thitu island, which is in the Spratly Islands chain and occupied by the Philippines. President Rodrigo Duterte’s administration has kept quiet, but it is coming under growing pressure from a Philippines congressman and a Supreme Court judge to take action or be charged with treason. This move by China could signal that while it appreciates Duterte’s more pro-China stance, the weakness of the Trump administration is too good an opportunity for it to hold back from further entrenching its position in the South China Sea. It remains to be seen whether China will also cross the red line that the US has drawn in the South China Sea — that China should not build military facilities on Scarborough Shoal, which it seized from the Philippines some years ago.
Global liquidity will not be a soothing balm for much longer
In other words, the chances of a big political change upsetting markets have grown. The remaining question then is whether the massive liquidity that has helped markets bounce back from political shocks will remain supportive.
There is little doubt, however, that global liquidity conditions will tighten over time — the only question is how quickly this will happen.
- The US Federal Reserve has telegraphed its intentions very clearly — it will start reducing the size of its balance sheet “relatively soon” and will continue to raise rates, albeit cautiously. If our assessment that growth and inflation will surprise on the upside is correct, the pace of monetary tightening will increase.
- The European Central Bank has also started to prepare markets for a shift in its monetary policy. Although the recovery in the eurozone is in its early stages, there is also a lot more pressure on ECB president Mario Draghi to normalise monetary conditions as soon as possible.
- Finally, as the global economic recovery picks up momentum, more of the existing financial liquidity will be absorbed by the real economy. With recovery, companies will need more financial resources for their business, so there will be higher demand for credit and much more equity issuance. Consequently, there will be less surplus liquidity that will flow into, and support, asset markets.
Conclusion: Expect more political risks and more sustained downside in asset markets
In short, investors must not be complacent about political risks. There is a stronger likelihood of unpleasant political surprises that could cause significant damage. And, unlike recent years, liquidity conditions will not be so supportive as to allow financial markets to bounce back relatively quickly from such shocks.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy
