Politics and markets: it's complicated

Politics affect markets

Among the many factors that can affect market performance, political events are perhaps the most difficult to predict. But they frequently have significant implications for investment decisions.

What we know is that economic and political stability is paramount for stable and growing markets. So if instability of any kind is coming your way, then expect markets to go down (with a few exceptions). And this is why it has been so strange in the past couple of weeks to witness stable and growing markets  despite major changes in the political landscape (or changes in political expectations), both in Europe and the US:

• a Labour government has been voted in the UK (by a landslide) for the first time after 14 years
• a major win by the National Rally (far right) in France, to be confirmed in a second round of voting this week-end
• a Presidential debate leaving President Biden behind (with a far worse performance than expected) vs the felon Mr Trump => this is not an election yet but has moved voters preferences

In a different market environment, this change of scenery would have prompted some equity sell-offs (including in the UK where Labour is already promising higher taxes). But not this time. Is this a show of strength for equity markets in a secular bull, while bonds seem to have finally stabilized?

(If you are interested to read more about how political risk can affect markets, here's a short primer from PIMCO.)

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Market updates according to the news

News would report the following:

=> stock markets remain at record high on the back of a solid job report issued on Friday in the US

=> In fact, the U.S. added 206k jobs in June in line with expectations, even if the unemployment rate ticked up to 4.1% from 4% in May (not a big deal)

=> Bond yields dropped following Friday's jobs report with inflation going credibly back to its 2% target

=> Cryptocurrencies slumped as the custodian of defunct exchange Mt. Gox began making payouts of nearly USD 9 billion to former creditors, which is expected to prompt significant selling.

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So what?

The above round of updates is accurate and fair. The issue we have with daily updates is that they tend to miss an interpretation on why things are happening in a certain way. Without knowing the WHY it is difficult to position investment portfolios intelligently, right?!

Let's take an objective look at the most recent dynamics to understand what is going on:

• We confirmed the stability in equity markets with the charts below (looking at last month's performance)

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• It is true that the US market has been performing way better than Europe

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• It would be tempting to say that Europe's relative under-performance this is due to political instability, but in reality it started in January (with a break in April of this year) and has deteriorated from early May. We believe it is more likely due to lower strength in the overall regional economy of Europe, where exports to China remain challenged and where industrial production remains subdued, as we can see in the Manufacturing PMIs (in contraction) for the region.

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• If not in equity performance, some kind of instability is evident in a pick-up of volatility by the European VIX (look at the right side of the chart below) not present in the US VIX (second chart)

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• Looking at government bonds, investors have suffered this year one more time (look at rising yields so far in 2024...meaning lower prices across the board)

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• But things have improved in the past week, with some yield compression (prices up) evident everywhere thanks to lowering inflation

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• If you have your investment portfolios long bonds, you would be happy to see some performance (especially for longer duration assets). The market is still rewarding investors to stay put in cash products though: take a look below to see that USD cash is paying better than any bond (same in Europe).

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• if you are light in bond duration, THEN it might be interesting to add some for the upcoming months as we get closer to possible rate cuts, still priced-in for October or November both in Europe and US (see charts below on what Futures markets are pricing-in)

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In summary

Markets are going ahead steadily, untouched by recent political updates. Bonds have improved on lower inflation, Stocks markets are stable/growing as the economy continues to expand.

It is evident that the US economy remains in better shape than Europe with a subsequent over-performance of the stock market (likely to continue).

Investors remain happy to take risk as evidenced by a preference for cyclical equity sectors (see chart below for the US, same happening in Europe) vs defensives.

Our portfolio remains happy to invest in risky assets for now.

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Watch out that French elections might bring some instability and might prompt in a very bad scenario the ECB to cut rates, but this scenario remains highly unlikely for now.

Thanks for reading!

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