Populism and interpreting underappreciated market risks

Global equity markets once again in 2016 and early 2017 defied the so-called experts by shrugging off Brexit and Donald Trump's victory. The Dow Jones industrial average hit an all-time high just five days after Mr. Trump's inauguration, despite market pundits predicting Armageddon.

There is good reason for such exuberance. Purchasing Managers' Index in Europe and Japan are seeing multiyear highs while expectations for long-term U.S. earnings growth are over 12% and U.S. equities are scaling new heights fueled by a “good news” narrative; based largely on expectations of lower corporate taxes, fiscal expansion and the unleashing of so-called animal spirits as regulations are rolled back by Republican control of both the White House and Congress.

However, in such environments, it is important for investors to critically evaluate whether these consensus assumptions may either be unrealistic or be ignoring important risks that could undermine them; or that the post-election rally might have already brought forward the implementation of such earnings-boosting policies and thus are vulnerable to mean reversion. 

For example, because they are expected to disproportionately benefit from corporate tax reform, small-cap stocks are now trading worryingly close to two standard deviations above their long-term average. 

The industrials and materials sectors, as well as certain Latin American markets that are most exposed to these sectors, also have seen stratospheric appreciation from the combination of Chinese reflation (which is waning) and infrastructure spending expectations. Bank stocks have also benefited from the combination of a steepening yield curve and a rollback of the Dodd-Frank Wall Street Reform and Consumer Protection Act; although they still trade at reasonable levels relative to their long-term average.

The retreat from globalization, power conflicts in Asia and conflicts in the Middle East all pose underappreciated risks that can significantly affect a global portfolio. On the flip side, we believe some risks, such as repeat of the euro-skepticism that played out in the U.K. and, to some extent, the U.S. elections, might be overstated. 

The U.S. withdrawal from the Trans-Pacific Partnership is but the first salvo in an apparent shift toward increased isolationism and mercantilism. Historically, corporate profits and globalization have been positively correlated because as globalization intensifies, global trade links deepen and “borders fall,” boosting companies' international revenue exposure. The opposite occurs under deglobalization. Typically, higher top-line growth from foreign markets has also been associated with increasing overall sales and profitability.

Sino-American symbiosis (America purchases/borrows and China exports/lends) is becoming frayed in part because China has become less dependent on exports than it was just 10 years ago. First, deleveraging prompted by the global financial crisis sidelined the U.S. consumer as the engine of global growth. Second, China's concerted attempts to increase local consumption, has resulted in exports falling to closer to 20% of Chinese gross domestic product now from 37% in 2006. Moreover, China's economic ascendancy has fueled an increasingly aggressive assertion of regional dominance.

The potential for conflict is twofold: 

1. China will not be able to continue to capture global market share while exporting deflation, particularly now that its higher-value exports are encroaching on developed market economies.

2. The Trump administration's promise to “get tough” with China on trade will likely be met by robust Chinese resistance, because unlike Japan in the 1980s, when the Reagan administration successfully exacted a huge appreciation of the yen and imposed voluntary export restraints, China is by far the largest importer of U.S. goods and, most importantly, is an independent political actor that does not rely on the U.S. for security. In this regard, the Trump administration's recent acceptance of the “One China” policy and seeming retracement of more bellicose pronouncements on the South China Sea are encouraging.

There are three potential Middle Eastern conflicts where the less quantifiable risks need to be carefully analyzed. 

The first is Islamic State group territorial defeats in Syria and Iraq, leading to disbursement of the group into local terrorist networks in Turkey and Europe. Expanded IS attacks in Europe would stoke nationalistic, anti-immigrant and populist support. In Turkey, they would embolden President Recep Tayyip Erdogan's authoritarianism. 

The second is a Turkish escalation in Syria, provoking Turkish-Russian conflict. Any Turkish-Russian conflict, if allowed to escalate, could lead to interdiction of Russian shipping through the Bosporus. This is a threat to our otherwise positive outlook for Russian risk assets and could add to risk premiums across the region as well.

Finally, the potential escalation of proxy wars between Saudi Arabia and Iran. This, we believe is a somewhat overstated risk. Saudi Arabia already has effectively surrendered in Syria and is looking for an exit in Yemen, but would defend any further Iranian meddling in its vassal state of Bahrain or elsewhere in the Gulf Cooperation Council, should Iran feel emboldened by its success in Syria. In this scenario, there would be a temporary geopolitical premium attached to oil prices. But this will ultimately bring more shale production on-stream.

While refugee migration and terrorism are real sources of social angst, Europe's social welfare state bureaucracy has blunted globalization's negative redistributive impact on its middle class. This is why populism is a somewhat overstated threat, particularly in Northern Europe.

Barring a high-profile terrorist attack, populist parties are unlikely to prevail. Support for the euro remains strong in France and Germany. However, European assets should surprise to the upside both because of the overestimation of the risk of populist parties prevailing and the relatively attractive fundamentals (valuation and higher operating leverage to global growth).

Between these potential conflicts in the Middle East, power struggles in Asia, populism sweeping politics as elections in France and Germany approach, and the growing uncertainty stemming from the disorder in the White House leading to constitutional showdowns with the judiciary, it's no wonder policy uncertainty is now at an extreme, according to the Global Economic Policy Uncertainty Index. 

Tina Byles Williams is CEO and chief investment officer of FIS Group Inc., Philadelphia. 

This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.