Strategies for Investing in the Global Economy Based on Political Events

HOW TO TRADE GEOPOLITICAL RISKS?

• The worldwide economy is displaying escalating vulnerability and delicacy,
• Diminishing economic strength leaves markets susceptible to geopolitical hazards,
• Instances of political menaces in Asia, Latin America, and Europe.

ANALYZING GEOPOLITICAL RISKS

Amidst deteriorating fundamentals, financial markets become increasingly sensitive to political hazards, which possess the potential to trigger widespread volatility. The clash between liberal-oriented ideologies, advocating free trade and integrated capital markets, and the surge of nationalist and populist movements worldwide introduces uncertainty-driven turbulence.

The treacherous and elusive nature of political risk lies in investors' limited capacity to accurately price it in their assessments. As a result, traders may find themselves in a state of agitation as the global political landscape continues to evolve unpredictably. Similar to the contagion effect witnessed during the spread of the coronavirus in 2020, political pathogens can swiftly transmit and affect various markets.

In general, markets are indifferent to political labels and primarily concerned with the economic policies pursued by the ruling authority. Policies that foster economic growth act as alluring attractions for investors seeking the highest returns on their capital.

These growth-stimulating policies encompass fiscal stimulus plans, strengthened property rights, unhindered flow of goods and capital, and the elimination of growth-restricting regulations. If such policies generate sufficient inflationary pressures, the central bank might respond by raising interest rates, thereby increasing the returns on local assets and attracting investors while bolstering the national currency.

Conversely, governments inclined towards anti-globalization tendencies may incite capital flight. Regimes seeking to dismantle the fabric of economic and political integration instigate uncertainty, deterring investors from navigating such environments. Themes like ultra-nationalism, protectionism, and populism have been consistently disruptive to financial markets.

During a state's ideological realignment, traders carefully evaluate the situation to determine if it significantly alters their risk-reward framework. If so, they may reallocate their capital and revise their trading strategies to favorably tip the balance between risk and reward. However, this process intensifies market volatility as the reshaped trading strategies are reflected in the redistribution of capital across various assets.

EUROPE: EUROSPETIC POPULISM IN ITALY

Amid the 2018 Italian election upheaval, regional markets were roiled, and the entire financial system experienced significant volatility. The rise of the anti-establishment right-wing Lega Nord and ideologically-ambivalent 5 Star Movement, driven by a populist campaign and rejection of the status quo, led to increased uncertainty under the new regime.

As a result, the risk premium for holding Italy's assets surged, leading to a staggering over-100 percent spike in Italian 10-year bond yields. Investors demanded higher returns to bear what they perceived as a higher level of risk. This sentiment was mirrored in the dramatic widening of the spread on credit default swaps on Italian sovereign debt, heightening fears that Italy could become the epicenter of another EU debt crisis.

The effects of this turmoil were not limited to Italy alone; they reverberated through the eurozone. Consequently, both the EUR/USD and EUR/CHF pairs plummeted as Mediterranean sovereign bond yields soared, exacerbating concerns over the possibility of another Eurozone debt crisis.

The US Dollar, Japanese Yen, and Swiss Franc all prospered while the Euro faltered, as investors reallocated their funds to safe-haven assets. The Euro's downturn was exacerbated by a conflict between Rome and Brussels regarding the former's budgetary objectives. The government's fiscal uniqueness became synonymous with their anti-establishment stance, leading to heightened uncertainty and subsequently a depreciating Euro.

LATIN AMERICA: NATIONALIST-POPULISM IN BRAZIL

Jair Bolsonaro's ascent to power as a fire-brand nationalist with populist underpinnings might have raised eyebrows, but the market reaction was surprisingly enthusiastic, welcoming him with open arms. Investors eagerly embraced his appointment of Paulo Guedes – a University of Chicago-trained economist known for his penchant for privatization and regulatory restructuring – which significantly bolstered sentiment and instilled confidence in Brazilian assets.

The Ibovespa stock index, which measures the performance of Brazilian companies, soared by more than 58 percent from June 2018 to the start of the Covid-19 pandemic in early 2020, while the S&P 500, a US index, only increased by a little over 17 percent in the same period. The Brazilian market surged by more than 12 percent in October alone, as Bolsonaro gained an edge over his leftist rival Fernando Haddad in the polls.

Bolsonaro’s market-friendly pension reforms have been the main driver of the market fluctuations in Brazil since he took office. Investors hoped that these structural changes would help Brazil avoid a recession and boost its economic growth, by reducing the public spending burden.

ASIA: HINDU NATIONALISM IN INDIA

The renewed mandate for Prime Minister Narendra Modi was warmly embraced by markets, with many applauding his business-friendly approach. However, there were lingering concerns regarding the impact of Hindu nationalism on regional stability. Despite this, investors remained enthusiastic and poured substantial capital into Indian assets.

Yet, their optimistic outlook has been periodically shaken by recurrent clashes between India and its neighbors over territorial disputes. The early months of 2019 witnessed a sharp deterioration in India-Pakistan relations due to a skirmish over the disputed Kashmir region. The historical hostility between these two nuclear powers has persistently posed an ever-present regional risk since the partition in 1947.

India Nifty 50 Index, S&P 500 Futures, AUD/JPY Plummet Amid Reports of India-Pakistan Skirmish

Geopolitical frictions between India and China, notably the contentious border issue along the Line of Actual Control (LAC) in the Himalayan Mountains, profoundly unsettled Asian financial markets. The June 2020 clash, where more than 20 lives were lost due to confrontations between Chinese and Indian troops, heightened apprehensions about potential escalation and its ramifications on regional security and financial equilibrium. Access the comprehensive report here.

Market Turmoil Unfolds: India Nifty 50 Plummets, S&P 500 Futures Volatile, US 10-Year Treasury Yield Declines, USD/INR Spikes Post India-China Skirmish News

Nationalist campaigns and governments are fraught with political risk due to their inherent focus on showcasing strength and their reluctance to compromise, often seeing it as capitulation. During times of political turbulence and economic fragility, the consequences of a diplomatic breakdown are further exacerbated because nationalist regimes tend to be stubborn and resistant to timely resolutions of disputes.

Interestingly, US President Donald Trump and Indian Prime Minister Modi adopted similar strong rhetoric during their campaigns and within their administrations. Paradoxically, this ideological resemblance might actually lead to a strain in diplomatic relations between the two countries. In 2019, tensions escalated, and the markets expressed concerns that Washington might initiate another trade war in Asia, potentially opening a second front in India after its engagement with China.

HOW FX MARKET RESPOND TO THE ACTIONS OF GOVERNMENT AND CENTRAL BANKS IN GEOPOLITICAL AND ECONOMIC STRESS

For economies with high capital mobility, different policy-mix alternatives can trigger reactions in FX markets following economic or geopolitical shocks. Let's explore the distinctive impacts of each scenario on the local currency:

Scenario 1: Expansionary fiscal policy with restrictive monetary policy (tightening) = Favorable for the local currency.

Scenario 2: Restrictive fiscal policy with expansionary monetary policy (loosening) = Unfavorable for the local currency.

Scenario 3: Expansionary monetary policy (loosening) with restrictive fiscal policy = Unfavorable for the local currency.

Scenario 4: Restrictive monetary policy (tightening) with expansionary fiscal policy = Favorable for the local currency.

It's essential to recognize that for economies like the United States and currencies like the US Dollar, when fiscal and monetary policies move in the same direction, the impact on the currency can be ambiguous. Now, we will explore the effects of various fiscal and monetary policy remedies on currency markets in response to geopolitical and economic shocks.

SCENARIO 1 - FISCAL POLICY LOOSE, MONETARY POLICY BECOME TIGHTER

During May 2, 2019, after the FOMC decided to maintain rates within the 2.25-2.50 percent range, Fed Chair Jerome Powell characterized the relatively soft inflationary pressure as "transitory." This suggested that the slower price growth was temporary and would likely pick up soon. The US-China trade war contributed to the economic slowdown and muted inflation.

The implicit message conveyed was a reduced likelihood of a near-term rate cut, given the Fed's positive assessment of the fundamental outlook and the healthy trajectory of the US economy. This tone was less dovish than what the markets had anticipated, leading to a decline in the priced-in probability of a Fed rate cut by the end of the year, as seen in overnight index swaps, from 67.2 percent to 50.9 percent after Powell's comments.

Meanwhile, the Congressional Budget Office (CBO) projected an increase in the fiscal deficit over a three-year period, coinciding with the central bank's tightening cycle. This was amid speculation about a bipartisan fiscal stimulus plan, including a US$2 trillion infrastructure building program announced in late April.

The combination of expansionary fiscal policy and monetary tightening created a bullish outlook for the US Dollar. The fiscal package was expected to stimulate job growth and boost inflation, potentially prompting the Fed to raise rates. Consequently, the Greenback gained 6.2 percent against its major currency counterparts over the following four months.

SCENARIO 1: DXY, 10-YEAR BOND YEILDS RISE, S&P500 FUTURES FALL

SCENARIO 2 - FISCAL POLICY TIGHT, MONETARY POLICY BECOMES LOOSE

The global financial crisis in 2008 and the subsequent Great Recession had far-reaching effects on economies in the Mediterranean region. This led to concerns about a potential region-wide sovereign debt crisis as bond yields in countries like Italy, Spain, and Greece surged to alarming levels. In response, some countries were compelled to adopt austerity measures, which laid the foundation for the rise of Eurosceptic populism in the region.

Investors began to doubt the ability of these governments to manage their debt, leading to a demand for higher yields due to the perceived increase in default risk. The Euro also suffered amid the turmoil, with doubts emerging about its survival in the event of a member state leaving the Eurozone.

A pivotal moment in this crisis occurred when European Central Bank (ECB) President Mario Draghi delivered a significant speech on July 26, 2012, in London. He reassured the markets by stating that the ECB was fully committed to preserving the Euro and would do whatever was necessary, assuring them it would be sufficient to tackle the challenges. This statement helped stabilize European bond markets and brought yields back down.

To further alleviate stress in sovereign debt markets, the ECB introduced the "Outright Monetary Transactions" (OMT) bond-buying program, aimed at providing relief to struggling Eurozone governments. Although OMT was never implemented, its mere existence helped calm nervous investors. Concurrently, many of the troubled Euro area countries implemented austerity measures to restore stability to their government finances.

Despite the initial rise in the Euro as concerns about its collapse eased, the currency depreciated significantly against the US Dollar over the following three years. By March 2015, it had lost over 13 percent of its value. This depreciation can be attributed to the specific monetary and fiscal policies in place during that period.

SCENARIO 2: EURO SIGHS RELIEF - SOVEREIGN BOND YEILDS FALL AS INSOLVENCY FEARS ARE QUELLED

Many countries in the Eurozone had to cut their public spending to deal with their debt problems. This made it harder for them to use fiscal policy to stimulate their economies, create more jobs and increase inflation. Meanwhile, the central bank was lowering interest rates and buying bonds to ease the crisis. As a result, this mix of policies made the Euro weaker against most other major currencies.

SCENARIO 2: EURO SOVEREIGN BOND YEILDS FALL

SCENARIO 3 - MONETARY POLICY LOOSE; FISCAL POLICY BECOMES TIGHTER

When the Great Recession hit, the Bank of Canada (BOC) lowered its key interest rate from 1.50 to 0.25 percent to make borrowing cheaper, boost confidence and stimulate economic growth. Surprisingly, the interest rate on 10-year Canadian government bonds started to increase. This rise happened around the same time as Canada’s main TSX stock index reached its lowest point. 

SCENARIO 3: USD/CAD, TSX, CANADIAN 2-YEAR BOND YEILDS

The recovery in stock prices and confidence after the recession made investors more willing to take risks and invest in stocks (which offer higher returns) instead of bonds (which are safer but lower-paying). This shift in capital allocation pushed up bond yields even though the central bank was making money cheaper. The BOC then started to increase its interest rate again and kept it at 1percent for five years.

During this period, Prime Minister Stephen Harper cut public spending to balance the budget amid the global financial crisis. The central bank then changed direction and reduced rates to 0.50 percent by July 2015.

Both the Canadian dollar and bond yields fell as monetary policy was relaxed while fiscal policy was restricted. Cutting government spending at this hard time turned out to be a bad move for Mr Harper. He lost his job to Justin Trudeau, who won the 2015 general election.

SCENARIO 3: USD/CAD, CANADA 2-YEAR BOND YEILDS

SCENARIO 4 - MONETARY POLICY TIGHTER; FISCAL POLICY BECOMES LOOSE

The US Dollar rose after Donald Trump won the 2016 US presidential election. The markets thought that having the Republican Party in charge of the White House and Congress would reduce political uncertainty.

They also expected that Trump would deliver on his promises of tax cuts, deregulation and infrastructure spending. These policies were seen as good for the economy. The markets did not pay much attention to Trump’s plans to start trade wars with major partners like China and the Eurozone, at least for a while. On the other hand, the central bank was tightening monetary policy. It raised rates at the end of 2016 and planned to raise them more by 75 basis points in 2017.

The US Dollar went up along with bond yields and stock prices. This was because the markets believed that the economy and corporate profits would improve. They also anticipated higher inflation and a more aggressive central bank response.

SCENARIO 4: US DOLLAR INDEX (DXY), S&P500 FUTURES, 10-YEAR BOND YEILDS (CHART-7)

WHY POLITICAL RISKS MATTER FOR TRADING

Many studies have found that when people’s living standards drop because of war or a big recession, they are more likely to support extreme political views. This means that they are less likely to favor policies that promote economic openness and integration, such as free trade and capital flows. Instead, they tend to prefer policies that are more isolationist and inward-looking.

The global economy is closely linked both politically and economically, so any major shock can have ripple effects around the world. When there is a lot of political instability and ideological shifts across continents, it is important to keep an eye on these developments because they can offer opportunities to plan short, medium and long-term trading strategies.

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