Market Watch: Emerging threats to developed markets

One of the most significant trends over the last decade has been the increasing influence of politics in the financial markets of advanced economies.

This follows a long period when politics was not a meaningful factor in asset allocation or stock selection decisions.

We came into 2019 with political dysfunction on both sides of the Atlantic, with the U.S. government shutdown being symptomatic of deeper issues, paralysis in the U.K. as the government struggles with Brexit, and ongoing political tensions in Europe, particularly France and Italy.

While developed market money managers have wrestled with the impact that politics is having on financial markets, emerging market specialists view these situations with a much greater sense of familiarity.

This leads to an important question: are developed markets exhibiting an increasing number of traditionally emerging market traits?

The attributes most commonly associated with developed economies are strong and inclusive institutions, rule of law and property rights.

The combination of these characteristics creates an incentive structure for people to work hard and fosters innovation, which leads to productivity gains.

The result is higher per capita real income, which is the most widely accepted measure of whether a country is considered developed.

The U.S., the U.K. and parts of Europe, have recently faced a litany of accusations that they are exhibiting traits usually associated with emerging markets.

From attacks on the media, questioning central bank independence, risks around potential nationalization of industries such as mail, rail and utility companies, and the appointment of family members in prominent policy roles.

President Trump’s recent comments directed at the Federal Reserve (Fed) have attracted a lot of attention. When asked about the biggest risk to the outlook, he replied, “to me the Fed is the biggest risk, because I think interest rates are being raised too quickly.” Undermining the credibility of an institution such as the Federal Reserve is potentially a very slippery slope.

However, in reality, central banks are political institutions and it is their actions relative to prevailing economic conditions that matter most.

Furthermore, there is a good argument to be made that there should be far more coordination between monetary and fiscal policy.

Indeed, the increased coordination between the Bank of Japan and the Ministry of Finance has done nothing to undermine confidence in Japan or the yen.

There is a long way between this and a president appointing their son-in-law as finance minister, which is what happened in Turkey last year.

A market-based judgment of whether a country should be considered developed comes from the sovereign bond market.

Specifically, how bond yields respond when a country’s growth outlook deteriorates. It is quite clear that both U.K. and U.S. government bond yields fall on bad news, as local investors consider their home currency as the true risk-free investment. In contrast, bond yields in emerging countries rise on bad news, as investors seek shelter in one of the reserve currencies, usually the U.S. dollar.

China is a particularly interesting case, by most definitions China is still considered emerging, but the growth slowdown last year was accompanied by a strong rally in Chinese government bonds.

However, the closed capital account and less developed legal system in China are at odds with advanced country status.

Leaving the European Union will involve a significant amount of upheaval in the U.K. Potentially leaving the world’s largest trading area and legal frameworks built-up over 50 years is a daunting prospect.

However, the adjustment mechanism here has been sterling and lower real yields. Confidence in the U.K. has undoubtedly been hit and investment has been postponed, but ultimately the U.K. institutions are likely to prove strong enough such that the U.K. becomes an attractive destination for investors when the Brexit uncertainty eventually lifts.

Overall, the populist tone of what is happening across much of the world does increase the risk that important institutions could be weakened.

Given the U.S.’s role in shaping the post-war system, these risks also extend to global institutions, which could make it more challenging to solve some of the ongoing geopolitical issues.

However, the case that the U.K. and U.S. are turning into emerging markets does not currently stand up to scrutiny.

Furthermore, China has been hugely successful at raising living standards but faces significant challenges before being considered a developed market.

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited.  The Bank accepts no liability for errors or actions taken on the basis of this information.

 

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