The results of the EU referendum and the US Presidential Election may have passed but that doesnt mean the political uncertainty has evaporated. There are still many questions left unanswered about the UK’s relationship with the EU and Trump’s economic policies are likley to remain a source of guesswork for many months.
Even more concerning are series of elections coming up in Europe. From the Italian referendum on the country’s constitution in early December to the French Presidential elections in April next year to the Dutch general election a month before. As WSJ highlight the biggest risk could come from a little known referendum law in the Netherlands that requires the government to hold a referendum on any law if 300,000 citizens request it. Dutch Eurosceptic parties now believe they have the means to block any further integration. They have already taken advantage of this law to secure a vote that rejected the EU’s proposed trade and economic pact with Ukraine, which Brussels saw as a vital step in supporting a strategically important neighbour.
Although you should be wary of the “law of small number” and the “gamblers fallacy” in drawing too much significance from a series of events there does seem to be an underlying trend towards populist uprisings in developed countries in the west just as perhaps the Arab Spring was the equivalent in the Middle East and North Africa.
At least one hedge fund manager is betting on the break-up of the EU. Hugh Hendry, founder and chief investment officer of Eclectica Asset Management said European politics posed the biggest market risk of 2017, with an impending French election the most likely trigger of fresh market ructions. Hendry said a parallel could be drawn with Britain’s withdrawal from the gold standard in 1931, when one key member leaving prompted others to follow. “Just one member leaves and it becomes extremely vulnerable.”
Market ahead of itself on inflation
Trump’s win has sparked speculation of a surge in inflation on the back of a big boost to infrastructure spending and protectionism, through higher demand in an economy already near full employment and the negative shock to supply that trade barriers would present.
Higher inflation expectations could prompt a more rapid increase in interest rates – hence gold’s surprise slump in recent sessions.
The markets may well be disappointed with the rate of increase in infrastructure spending in the US while for Trumps rhetoric over a war on global trade it appears much more likely that once in office he just limits his intentions to reducing the impact of the status quo rather than ‘building walls’.
There is a question mark over whether inflation may remain ahead of the yield curve – that is to say, whether it will rise faster than interest rates. If it does, real interest rates would be negative. This would trigger sell-offs of assets like bonds that are already in widespread retreat. Gold would thereby benefit.
The recent strengthening in US bond yields and the US dollar may be enough to slow the economy naturally to bring inflation expectations back in track. While the prospect of higher US interest rates may provoke another “Taper tantrum” in emerging markets that scares the Fed into delaying or smoothing the rate of interest rate hikes.
War on cash
Markets are likely to see support in the form of physical buying of precious metals. India’s crackdown on corruption resulted in 86% of the notes in circulation turning into worthless paper overnight. Although this may reduce the capacity of normal Indian’s to turn to gold it will be a warning sign to other countries citizens that their governments can and will resort to all measures to crackdown on corruption and to prop up their financial systems.
The risk: A sharp rise in bond yields
The main risk on the downside to this outlook is that global bond markets suffer a sharp selloff resulting in a spike in bond yields. According to SocGen “there is to our minds significant risk of a more disorderly repricing of global bond yields. Such a scenario could have very negative spillover, not least to emerging markets.”