With many of the world’s most powerful leaders struggling to maintain public legitimacy amid the economic downturn, a focus on short-term populist, nationalist and protectionist policy measures instead of comprehensive long-term reforms will likely increase. In this environment, the potential for self-inflicted policy failure remains the most significant risk, though muddling through is the most likely scenario. Citi Global Equity Strategist Robert Buckland notes that any resolution to the prevailing political uncertainty could provide a positive surprise to equity markets that have moved away from their historical emphasis on company fundamentals and are now focused on macro concerns, noting that politics were not an important driver of equity markets prior to 2008.
For some sovereigns, according to Citi Chief Economist Willem Buiter, the only way to relax budget constraints, even temporarily, would be through a discretionary, opportunistic default on sovereign obligations. The temptation to do so is likely to increase in the run-up to a closely fought election. These forces are increasing the uncertainty precisely when investors are looking to policymakers for decisive action.
The period ahead of elections is unlikely to see policymakers attempt reform. In the past, governments may have been tempted to indulge in fiscal loosening ahead of an election. Today, budgetary constraints make the notion of “sharing the proceeds of growth” through fiscal largesse a remote prospect for most leaders; instead, as Jean-Claude Juncker, head of the Eurogroup famously remarked, “We know what to do, we just don’t know how to get elected after we do it”. Because of this, we see policy failure as being the most significant political risk to markets and believe that muddling through is the most likely outcome. Positive political developments in Europe could trigger an increase in share prices.
Taken together, the impact of this concentration of important elections amid a worsening economic outlook threatens to have a significant impact on the overall business, investment and regulatory environment, as well as prospects for recovery. Although forecasting election outcomes may prove more challenging than usual due to the shifting social and political context where new actors, parties and ideas are vying for the support of increasingly disenfranchised electorates, in our view investors should do more than try to identify the winners. Instead, understanding the changing context for these elections and shifting global public opinion may prove more useful for anticipating the post-election environment. With policymakers in the US, Europe and emerging markets in “easing mode”, our European Equity Strategist Jonathan Stubbs thinks that equity markets could benefit from “synchronized liquidity” and no global recession in 2012, but the direction of global politics could make it a bumpy ride.
Figure 1. Global Election Timetable
Global Election Timetable
Source: IFES Election Guide – Election Calendar, World Events Calendar – Council on Foreign Relations, Citi Investment Research and Analysis. *TBC – date to be confirmed
Political Change in the “Big Four”?
Arguably in 2012, the most important elections or political transitions from a macro-economic and market perspective are the United States, France, Russia and China. Taken together, these four countries not only comprise 40% of global GDP but hold 4 of the 5 permanent United Nations Security Council seats and represent nearly 27% of the global population.
The challenges these four countries face encapsulate the most pronounced political risk themes: the ongoing battles over timing and fiscal burden-sharing of a resolution to the sovereign debt problems in the United States and France; anti-establishment sentiment and demand for reform in Russia; and a new generation preparing to take the reins in China.
Besides the elections and political transitions in the “Big Four”, elections in Greece (expected in April), Egypt (June), Venezuela (October) and Korea (December) could also impact the economic and geopolitical environment.
Divided US government and Gridlock Risk
US Equity Strategist Tobias Levkovich notes that historically, the election year cycle would have argued for big gains for US equity markets in 2011 as the third year of a President’s term is the best for equity investors. But the extraordinary challenges of large budget deficits amid substantial unemployment and deleveraging actions have created new uncertainties and led to subpar performance last year. Although the race for the presidency commands the most attention, because it is the United States Congress that controls the purse strings of the federal government, the composition of the House and Senate are quite important. Market risk is heightened as a divided government could prevail leading to a period of policy gridlock or, ironically, it could also spark historic reforms in dealing with the looming fiscal challenges. Nonetheless, an extended period of uncertainty and political infighting beyond the November 6th US elections could pose challenges for markets.
Reduced Room to Maneuver for Elected Officials in France
The outcome of the French elections on 22nd April is also of relevance to investors, given France’s leadership role in resolving the eurozone crisis and its economic weight within in the currency union. Concern from market participants about the policy priorities of Socialist challenger François Hollande, who currently holds a strong lead in the polls, has grown following his suggestion that he would renegotiate the EU fiscal compact. Regardless of who wins the presidency, European Equity Strategist Jonathan Stubbs notes there is no doubting the ongoing focus on the banking sector from all sides of the political spectrum. Away from banks, an incoming cash-poor French government may look to the corporate sector for additional revenues, leaving asset-heavy industries with a high concentration of domestically generated profits potentially more at risk. Whoever wins France’s elections in May, it is likely that France will continue to pursue fiscal repair over the coming years. Slippage from this path could be costly in terms of sovereign credit ratings and interest rates.
For equity markets, French and European, there are many political risks that could derail a positive start to 2012. However, liquidity could have a bigger impact on investors’ risk appetite and share prices over the coming year and policymakers seem to be lined in the same way. Meanwhile, incumbent President Sarkozy will officially announce his candidacy in the coming days and begin to campaign in earnest, with early indications suggesting a move to the right. As election day draws nearer, expect to see more shifting in opinion polls. Eurozone Economist Guillaume Menuet believes the race will go to the second round since none of the four leading candidates (Hollande 30%, Sarkozy 25%, Le Pen 20%, Bayrou 14%) can obtain more than 50% of the vote in April.
New Leaders at a Critical Juncture in China
China Strategist Minggao Shen notes that China’s dual elections, the Communist Party (October 2012) and the government reshuffles (March 2013) come during a time when China’s traditional growth model has almost exhausted its potential. Future growth can no longer rely on excess investment and external demand. A hard landing may be inevitable over the next few years unless marginal demand is generated, which should form the core of China’s new growth model. Any potential for genuine structural reforms associated with leadership change should lift market sentiment and move markets positively in the second half of 2012 and beyond. Optimism may then rise, as many would argue that new leaders will have no choice but to reform.
However, China’s new leaders will take over the government at a critical juncture in the country’s development. Among the challenges they will contend with are: growth will continue to moderate and there is a need to find a path to slower, more sustainable growth; finding an adjustment to the cost of capital, implying cost normalization through interest rate liberalization, RMB re-evaluation and capital account deregulation; and lastly de-regulation and privatization in upstream manufacturing and services in order to encourage the entry of private investors. Shen believes that these areas can act as new drivers of future growth, generating marginal investment and consumption. Beyond these domestic considerations, the tenor of the US-China relationship will also be in the spotlight, with the political transitions in the two countries happening at the same time for the first time in 20 years.
Russia’s first post-Soviet brush with political uncertainty
Citi’s Russian Equity Strategist Kingsmill Bond notes that this is the first time since 2000 that the Russian market has had to factor in domestic political risk; the market’s immediate response to the urban protests has been to widen the Russian discount by 200 points, slightly more than 10%. We believe that this uncertainty could continue beyond the elections, as market participants wait to see what kind of regime Putin will lead in his third term as president – assuming he wins, as polls indicate – whether introducing new reforms in response to protestors’ demands, which mainly focus on fighting corruption, or by reducing the space for political competition and attempting to maintain the status quo. Although the market has a 200 point cushion against mild shocks, it would fall if these tail risks transpired.
Bond sees significant tail risks over the next two months, between now and the second round of elections on 25th March. Tail risks for Russia include populist and nationalist rhetoric, divisions within business and/or political elites, and unrest on the streets. However, if tail risks do not materialize and initial post-election signals point toward reform, we would expect the discount of 200 points to turn into a premium of 100 to 200 points. The most likely timeframe for greater clarity will come in April, with the new government due to be inaugurated in May. Nearer-term, a key signpost will be the conduct of the elections themselves on March 4th, whether Putin wins in the first or second rounds, and if the newly-energized Russian public accepts the result as legitimate.
Populist Rhetoric – Bark Worse than the Bite?
Amid the economic gloom and volatile public mood, is the news all bad for companies and investors? This seems unlikely. While the public mood in much of the developed world has become more stridently anti-corporate, and especially anti-financial sector and anti-big bank, the one factor that underlies the wave of public protests and proliferation of new political movements is the desire for jobs and improvements in living standards, an outcome that is crucial for companies to realize.
Policies that induce companies to hire employees, result in the simplification of the tax code in a way that promotes greater efficiency and fairness, and boost international trade are all possible in our view – so long as they are framed as job-creating measures beneficial to the public good rather than corporate welfare, a policy deeply tarnished following crisis-era bailouts. With this in mind, the rhetoric employed in election campaigns may sound harsh, such as French Socialist challenger François Hollande’s statement that his true opponent is the financial services industry. Upon closer scrutiny, the policies he proposes diverge little from those being discussed – or in some cases already implemented – elsewhere in Europe.
Some industries will be impacted by forthcoming austerity-induced cuts, defense and healthcare potentially among them. But we expect that most cuts will not come until elections are past and new governments take office in 2013; even then, cuts will likely continue to be the subject of fierce political battles for many years to come. Piecemeal measures, such as wealth taxes, stealth taxes and financial transactions taxes, will likely continue to be more popular than wholesale reforms, disadvantaging the younger generations in favor of their older, more activist parents and grandparents. Meanwhile, leaders will hope that the worst of the crisis will be behind them before they must wield budget axes that could cost them public support; instead, they will likely strive for a return to as much of the status quo ex ante as possible. It could be a long wait.