“...apparently a woman rang the BBC and said she heard there was a hurricane on the way...well, if you’re watching, don’t worry, there isn’t!” - Michael Fish, October 15th 1987.
Investors have not had to look far for things to worry about in the last decade, from a collapsing, or latterly just limping, economy and banking system, to regularly convulsing electorates. The current calm seems disquieting by comparison. Is there indeed an absence of things to worry about? And should that absence itself worry us, as some say it should?
As we’ve pointed out before, the risk outlook is often best characterised as an iceberg. Most years, it is not the things you think you can see that provide investors with the jolts. Those worrying about the apparent lack of visible risks can take a little succour from the idea that the risk outlook appears to us much the same as it always does: mostly unknowable from our vantage point.
Nonetheless, for those looking for things to keep them up at night, below are some more substantial clouds for them to fret over.
Italian elections – grand coalition?
The Italians will trudge to the polls on March 4th to no doubt express their dissatisfaction with what remains the most worrying of the major European economies. They do so under a new voting law, Rosatellum, which is a mix of first-past-the-post used in the UK, and a proportional system. The fact that the Five Star movement protested heavily against the introduction of this new electoral law hints at what and who it is intended to stymie. Current polls indicate that a large, heterogeneous coalition will need to be formed. The likely best case is the ever familiar political stalemate and the worst, some backtracking on the important labour market and pension reforms enacted under Mario Monti and Matteo Renzi. Nonetheless, for investors with fingers already hovering over the sell button, there are a couple of things to keep in mind.
First, the birth of such a heterogeneous coalition is likely to be painful, but more importantly protracted. Second, even if EU-unfriendly forces were to manage to both win the election and form a workable coalition, the current constitution prohibits referendums on international treaties. To change the constitution, a two-thirds supermajority would be required twice (in both chambers) before the question could even be put to the electorate.
The Italian economy, beginning to enjoy the fruits of the wider European recovery, will have to get along without a strong government. However, Italians and indeed investors may not notice the difference.
UK – government collapse?
In the UK, some understandably fear the collapse of Prime Minister May’s government, and more elections. A vote of no confidence from Parliament, perhaps resulting from a failure to pass a piece of major legislation, may trigger fresh elections. The thin Conservative majority would also disappear if the DUP decided to walk out. So far, the fact that Jeremy Corbyn is a known supporter of a united Ireland likely keeps the latter in the unlikely realm.
Further political instability would no doubt complicate the UK’s progress with disentangling itself from the EU. For investors, such turbulence would surely infect sterling and even wider UK assets to a degree. However, we’re not currently taking pre-emptive action here. The economy has proved reasonably resilient to such shocks thus far. This resilience should actually improve over the course of this year as the imported inflation from the post-referendum sterling slump washes through the data, so easing some of the strain on a still fully employed consumer. Meanwhile, the increasingly noisy global economic party in motion outside of these shores should continue to buoy our exporters a little.
US - Trump
No list of political risks for the year ahead would be complete without a mention of the US administration. For the moment, we retain our admittedly guarded faith that constitutional safeguards and economic self-interest will continue to muzzle its least investor friendly impulses. However, the approach of midterms combined with still record low Presidential approval ratings may be influential. The sixth of seven scheduled rounds of negotiation over the NAFTA treaty begins next week in Montreal. A US withdrawal is still possible, but would likely hurt both the US and Mexican economy.
Oil and inflation
The recent surge in oil and wider commodity prices has coincided with inflation expectations ticking higher. Persistent price acceleration may prompt the Fed to overtighten monetary policy, bringing an end to the third longest business cycle in US history. It would certainly not be the first economic cycle that oil prices have killed. There are a number of factors that have helped to drive oil prices higher, from continued strong demand growth to a swelling bet that OPEC will extend their supply cuts. In our estimation, current levels should already be encouraging US onshore production back into the game, so helping to cap further material upside. There is certainly the potential for some short term overshoot, particularly with investors able to make relatively easy money trading the futures curve for the first time in a while. However, absent a major supply shock, it is hard to see the oil market becoming significantly undersupplied in the current global context.
None of these risks loom large enough for us to take evasive tactical action just yet. We are not expecting the currently serene markets backdrop to continue of course, but still see that increasingly vibrant economic backdrop in the driving seat for capital markets when all is said and done. Investors should be braced for a less comfortable ride, but invested for further strong global economic growth as a result. To that end, we have recently diversified our bet on developed equities, by shifting some of our exposure from US to Japan. Doing so would also allow us to capture a little more of the earnings pickup and growth acceleration we’re seeing outside of the US.