Could politics mess it all up?

21 October 2016

Key messages:

Politics take the front seat: en route for a bumpy Q4

  • Moderate recovery and slow rate rise at risk
  • Politics is taking over macroeconomic and financial perspectives with the rise of populism 
    • Risks are rising that we could see policy mistakes derail the recovery
    • Central banks’ independence is challenged by politics in several countries
  • Support for more accommodative monetary policy is fading inside and outside central banks
    • All central bankers in the developed world are considering tapering, but with caution and extreme concern
    • We expect the ECB to announce a three-month extension of its QE programme in December and start tapering by June
    • Fiscal policy is praised but we suspect that limited room for manoeuvre will mean more talk than action
  • US: if our baseline case of a Clinton victory would have limited effects, a Trump victory
    • Would mean more growth and rates in the short term if he limits himself to fiscal stimulus, but protectionism and immigration action could push the US economy and the rest of the world in a premature downturn
  • In this environment, we favour a fairly cautious asset allocation, though beware of volatility
    • All assets look richly priced to us, at a time central banks pretend to slowly withdraw some support
    • We introduce a negative bias on duration and prefer taking risk in credit rather than in equities. We maintain a strong carry bias through high yield and EM debt
    • While underweight equities, we have a preference for the US and EM markets over the euro area and Japan 

Key risks :

  • Heavy agenda ahead
  • A hard Brexit scenario has become more plausible
    • The impact on the real economy will only slowly diffuse but is building
    • The sterling depreciation will push the economy in stagflation, while a gilt yield spark would raise volatility and call the BoE into action
    • The Autumn statement, due on the 23rd of November, may address some but not all of these concerns with fiscal support
  • Polls are close on the Italian referendum but the worst-case scenario remains unlikely
    • PM Renzi has started distancing himself from the outcome of the referendum
    • Risk: a failed referendum would mean at best low reform dynamic, likely impact on yield and banks
    • Low but not null risk : forced new elections could lead to a majority for the Five-Star Movement, euro sovereign risk could be back and challenge the ECB
  • From a market perspective, the worst case would be a significant stress episode
    • Falling yields and widening credit spreads would hurt our allocation and not be fully offset by our defensive positioning in equities
    • This could be driven by a growth scare, financial instability or one of the above risk events materialising
    • Central banks’ communication around exit strategies will remain key in steering market expectations and asset prices