Has the West fired all its fiscal and monetary guns?

Published: Mar 2024
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Central banks have long been the ‘only game in town’ because markets danced to their tune, now they are in danger of being eclipsed by geopolitics. In the West, the chance of a populist surge is one of the most important political risks for financial markets.

Solar eclipse over the Sahara Desert

The undermining of Europe from within: the populist right

The successes of populist-right-wing politicians such as Meloni, Orban and Wilders have been discussed at length in the media. But will the populist right achieve more electoral victories this year?

In order to answer this question, it is important to realise the following:

  • The number of Europeans with views compatible with right-wing populist parties far exceeds the number of voters who have voted for them to date.

  • The populist reservoir has remained largely unchanged for several decades. Conservative ideology and anti-immigrant sentiment are by far the main drivers of populist sentiment. Economic factors are far less prominent, surprisingly enough.

  • Loyalty to traditional parties has been subject to severe erosion. In addition, said parties generally did not progress beyond offering old recipes for new/worsened problems, allowing populists to jump into this gap.

  • News about populists generates many readers, listeners and viewers. Thus, populists quickly receive(d) disproportionate attention from media compared to their actual support, which creates a self-sustaining effect.

  • People are less attached to democratic institutions than is widely assumed. People generally prioritise their day-to-day well-being. Expectations that voters will punish the undermining of the rule of law often prove unrealistic.

  • In countries governed by coalitions, it is harder for the populist right to push its own agenda. Look at Meloni who is far more moderate as prime minister than when she was in opposition.

  • Adverse conditions make it easier for politicians to fail. And when they fail, it feeds the discontent that the populist right can capitalise on.

In recent years, we have seen the effect of these mutually interacting forces in a host of European countries, including the Netherlands and Italy. This year will see national elections in Portugal, Belgium, Croatia and Austria, while several important regional elections will be held in Germany.

Apart from these votes, all eyes are on the elections for the European Parliament in early June. The success of the populist-right will likely remain relatively limited and the centre-right bloc will (once again) become the largest. The latter bloc is undertaking efforts to take the wind out of the populists’ sails through, for example, stricter asylum policies and a brake on climate change control policies.

Scholars point out that no clear advice can be given on whether such a strategy works. Sometimes, voters see the partial adoption of the populist right’s positions by centrist parties as a weakness, and the voter’s view seems to be: why vote for the light version when I can also vote for the original? Other times, it does work to partially adopt programme items from the wings, as is evident in some Scandinavian countries.

We might see a surprising rise of the populist-right in the above-mentioned elections. This is due to this enormous potential reservoir of votes, while conditions for centrist parties are challenging, to say the least. Dissatisfaction with the approach to climate change, faltering housing markets, migration and the erosion of public services are examples of factors creating frustration with incumbent politicians.

Trump on victory course

The US shares many of the problems Europe is encountering. American voters will have their say in November. Currently, Donald Trump has decent odds of securing a second term as US president:

  • Only exceptional circumstances – such as health problems or very surprising twists in his legal concerns, for example – could still keep Trump from the Republican nomination.

  • The likelihood of any negative Trump-related surprises surfacing during this election year is low. The man has been put under a magnifying glass, to the point where any embarrassing skeletons in the closet would have long been exposed. Americans have long been familiar with his coarse ways.

  • The vast majority of Americans currently feel that things are going in the wrong direction for their country, while a majority of Americans give the Biden administration a highly insufficient rating for its economic policies. Also, we believe the risk of economic surprises is greater to the downside.

  • There are considerable doubts about Biden’s mental and physical health (even among Democrats).

  • The global geopolitical climate is unlikely to improve much in 2024. The Ukraine war will drag on (and possibly even more so in Russia’s favour), relations with China will not improve substantially, and frictions between the West and the Global South will continue. If the global outlook grows more gloomy, this will contribute to Americans’ already pessimistic view of developments in their own country. And the current government will be held responsible.

  • In most major swing states, Trump is leading over Biden in the polls.

  • Betting firms give Trump by far the best odds of victory and so-called prediction markets also give the challenger considerably more chance than the incumbent president.

The aforementioned tension between debt piles, fiscal spending desires and earning capacities will become a big factor in the US. According to US auditors, the budget deficit will average 6% of GDP over the next decade.

Such deficits are already cause for concern, especially in view of the already high US debt-to-GDP ratio. However, the underlying assumptions are almost certainly far too optimistic. For example, Trump’s 2017 tax cuts are assumed to expire. This seems fairly unlikely, as does the assumption that so-called discretionary spending (including defence) will decline.

Over the last decade and a half, the monetary and fiscal purse strings could basically almost always be loosened to sweep problems under the rug/kick the can down the road. Under Biden, the results included mammoth investments in infrastructure and industry, ongoing stimulus programmes despite record low unemployment, the continuation of most of Trump’s anti-China measures and student loan forgiveness.

Such ‘solutions’ assume there is fiscal scope and/or flexibility on the part of the Fed to ultimately finance deficits monetarily. To put it bluntly, it was possible to remain on good terms with everyone as long as vast amounts of money were offered. Ultimately, either a new credit crisis will threaten or the Fed will have to turn the monetary tap all the way on again.

Consequences for markets and economy

EUR/USD – public finances are more likely to spiral out of control in a Trump-led America than in Europe. This will exert downward pressure on the dollar in the longer term.

Interest rates – government spending hard to curb: spending on defence, climate change/energy transition policies, pensions and healthcare will rise, while debts are already soaring. As a result, bond markets will start pricing in that Western governments will want/need to raise vast amounts of capital and that inflationary policies will become an ever-greater risk.

Equities – the slightly longer-term outlook for European and US shares is not bright, given expectations of rising interest rates, deteriorating public finances and mounting geopolitical tensions. What merits a separate mention is the risk that Russia will see even more opportunities to destabilise the West if Trump returns to power.

The above may cause equities to struggle via various avenues:

  • Unsustainable public deficits will lead to higher taxes on profits and capital gains.

  • Geopolitical tensions make cross-border investments far more risky.

  • Deglobalisation is making it harder for companies to produce more efficiently and tap into larger markets.

  • Ageing populations lead to higher rather than lower labour costs.

Gold – gold will be in a strong uptrend over time, given the increasing geopolitical uncertainty, concerns about public finances as well as fears of inflationary policies being pursued.

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