Markets largely welcomed major policy developments in 2017, including a major US package of individual and corporate tax cuts, the Trump administration’s deregulation efforts, and the election of the pro-growth, reform-minded Emmanuel Macron in France. This pushed global markets to new highs.
POPULIST CONCERNS RE-EMERGE IN 2018
In contrast to 2017, 2018 has seen a revival of concerns about a turn towards populism—particularly trade protectionism. Many of these worries centre on the Trump administration, which has:
- Raised tariffs on steel, aluminium and possibly auto imports.
- Demanded large reductions in China’s trade surplus with the US.
- Pushed for concessions from Canada and Mexico in talks to revamp the North American Free Trade Agreement (NAFTA).
Other political risks include:
- Continued lack of progress in working out a post-Brexit trade relationship between the UK and the EU.
- Political disarray in Italy following the election of a populist coalition promising relief from fiscal austerity.
- A soaring federal budget deficit in the US.
NEAR-TERM RISKS ELEVATED
In our view, these issues have elevated the near-term risks of a major policy shock, which contributed to the volatility seen in the first quarter. The threat of a US-China trade war is especially unsettling, given that it would involve the world’s two biggest economies. Emerging economies tend to revolve around China, so a meaningful conflict between the two largest economies in the world is a serious risk to markets.
BOND MARKETS MAY BE VULNERABLE
While buoyant earnings helped global equity markets rebound from policy-related “risk off” episodes in the first half of 2018, the US bond market could be more vulnerable. Non-US buyers have accounted for roughly half of the demand at recent Treasury auctions. However, current interest rate differentials also make it possible for Chinese and Japanese investors to purchase German or French government bonds, hedge their currency exposure into US dollars and earn a combined return that in some cases is higher than the yields on comparable Treasuries.
US Rates Rose Significantly in Early 2018
US Treasury Yield Comparisons
As of May 31, 2018
Yields are based on benchmark US Treasury notes
Source: FactSet Research Systems Inc. All rights reserved.
While global growth remains strong, populist policies remain a near-term threat to the world economy. Trade protectionism – particularly a potential trade war between the US and China – may lead to significant volatility in the near term, especially in bond markets. To hedge against political risk, investors may wish to position their portfolios more conservatively as we enter the second half of 2018.
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