Anti-establishment parties are primarily criticising the past decisions of established parties.
Government spending over the past 20 years has exploded, taking debt-to-GDP ratios to record highs. But the taxpayer money invested in each economy has largely failed to increase standards of living.
The now-necessary fiscal cuts that are looming at the same time as public frustration about inequality and lower living standards is rising helps explain the current political situation.
In the aftermath of the Great Recession, public money happened to be used heavily, both to support growth and to save the financial institutions that needed to be bailed out. The average debt-to-GDP ratio rose from 65 to nearly 100 per cent.
There are of course differences between countries, from the 130 per cent of Italy to the 45 per cent of Switzerland, but the average ratio has risen as nominal GDP growth has lagged the surge in public spending. Previous recessions have been followed by such a debt surge, but this time governments have shown weaker control than usual over their expenditure.
Average debt to GDP ratio, 1980-2020
Source: IMF, Unigestion’s calculation. The sample covers Austria, Belgium, Canada, Finland, France, Germany, Ireland, Italy, Japan, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom and the United States.
This surge in public debt has led various countries – especially European ones – to implement spending cuts – at the cost of creating disgruntlement among their citizens.
Public finance normalisation is usually not obtained at the expense of the wealthiest part of the population and disgruntlement is now visible in many democracies. The rise of Syriza in Greece has mainly been the reflection of the public frustration triggered by the previous government’s fiscal policy.
Many populist movements see in this fiscal strain one of the reasons for the recent decline in GDP per capita: the next chart shows this metric barely improved in the 2008-2014 period, and has been declining more recently.
This is just an average and the dispersion around it does not favour people on the lowest incomes. This has been seized upon by anti-establishment parties. The political status quo is now increasingly seen as having lost control of their respective economies and this may well take its toll in forthcoming votes.
Developed countries' GDP per capita in USD, 1980-2020
Source: IMF, Unigestion’s calculation. The sample covers Austria, Belgium, Canada, Finland, France, Germany, Ireland, Italy, Japan, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom, and the United States.
How markets see the issue
CDS and currency volatility have long been used as gauges of political and country risk. How well do they reflect this phenomenon today?
The following two charts respectively show the CDS and real exchange rate volatility for the US, the UK and a number of eurozone countries. On both charts, the start of the Greek crisis, the European crisis of 2011 and the outcome of the Brexit vote are clearly visible. Brexit is more apparent in forex volatility than CDS spreads. However, both charts deliver the same message: if political risk is on the rise, it is barely registering in the European and US markets.
The pricing of political risk for both these regions is limited; that is all the more reason to be cautious. The main reason for this apparent lack of risk aversion is probably because of central bank action: quantitative easing (QE) specifically aims to reduce risk aversion in financial markets and since 2009 it has worked perfectly. The Federal Reserve (Fed) and European Central Bank (ECB) managed to reduce the risk premium over the past 8 years, but they are now giving signs that they are in the process of changing direction.
An additional QE package from both the ECB and the Fed is now unlikely, opening the door to a potentially much more violent repricing of political risk: this risk will definitely matter in the forthcoming quarters.
Country CDS, 2004-2016
Source: Bloomberg, Unigestion’s calculation. “Europe” is the average CDS for Austria, Belgium, Finland, France, Germany, Ireland, Italy, Portugal and Spain.
Real exchange rate volatilities, 2001-2016
Source: Bloomberg, Unigestion’s calculation. “Europe” is the average real exchange rate’s volatility for Austria, Belgium, Finland, France, Germany, Ireland, Italy, Portugal and Spain.
Conclusion
Political risk is on the rise, yet markets show little sign of pricing this in. There are fundamentals explaining its rise, and most of them will remain with us for an extended period of time: globalisation, lower standards of living and limited government leeway to change these fundamentals, fuelling popular frustrations.
The US elections and later the Italian referendum are the next two events that investors should follow cautiously, especially as next year will feature potential anti-establishment votes.
We recommend using forex and equity volatility to hedge this risk as these are the assets that show the strongest connection to such episodes of heightened volatility and the drying up of liquidity.
The only caveat is that these approaches ought to work provided the political risk creates only short-term shocks and not a longer-lasting blow to markets.
Florian Ielpo is head of macro research, cross asset solutions at Unigestion while Stéphane Dutu is fundamental analyst, equities and Jérémy Gatto is trading, equities. The views expressed above are their own and should not be taken as investment advice.