We are nearing the end of an era. And by that, we do not just mean the question of how much longer the current cycle can last. That question is addressed at length on the following pages. In this piece, we instead want to look at some seemingly distinct upcoming events, broadly subsumed under the category of political risk.
Brexit day is fast approaching. On March 29, the UK is scheduled to leave the European Union. Nobody quite knows how bad things might get in the absence of a withdrawal agreement of some sort getting passed by parliament in Westminster and the UK's European partners. Markets abhor this sort of uncertainty. For now, most investors are counting on something getting passed, if only an extension. That would certainly fit with the pattern so far of difficult decisions being avoided, especially on the British side.
Then, there are various electoral events, including Spain's snap parliamentary vote and elections to the European parliament from May 23-26 of this year. Based on past experience, plenty of investors appear ready to contemplate populist upsets, potentially with negative market consequences. Add ongoing trade conflicts between U.S. President Donald Trump and much of the rest of the world, and it is no wonder that investors are quickly learning to expect the unexpected. At times, markets gyrate between gloom and euphoria, depending on the latest presidential Tweet.
You will notice some common threads. In all these instances, investors tend to extrapolate from recent experiences. That is a very human reaction when faced with uncertainty. Often, a hefty dose of wishful thinking is added, along the following lines: "Well, there are presumably rational people on all sides. Voters and policymakers must know the harm they are likely to cause, not least to themselves. Surely, they will decide in ways that I would find sensible."
It was precisely this sort of thinking that led markets to underestimate the likelihood of the UK voting to leave the European Union in 2016. And yet, the Brexit vote was not all that unforeseeable based on the polling data. Nor was Trump's win in the Electoral College (despite losing in the popular vote). As we argued in our May 2018 Special on global trade, China, rather than Brussels or Mexico, may have played an outsized role. In both instances, the distribution of the vote suggests a strong correlation between voting patterns and localized economic decline initially triggered by surging imports from China. This, in turn, may have contributed to anti-immigrant sentiment, whether or not migration had a material impact in any particular geographic area.
It is such often surprising patterns that we try to use to analyze and anticipate political risks. For decades, voting behavior has become less predictable, leaving plenty of scope for electoral surprises. In turn, such surprises increase the likelihood of potentially damaging political accidents; the looming prospect of a hard, chaotic Brexit is just one vivid example. Electoral surprises, however, rarely come out of the blue. More often than not there are plenty of clues helping identify underlying patterns. On Brexit, such an approach highlights policy dilemmas well beyond the question of any "deal" or "no deal." On trade more broadly, it suggests that the backlash against globalization may prove quite more sustained. Resistance against free trade appears to have deeper causes than the idiosyncratic policy preferences of the current U.S. President.
Few of such patterns are universally valid, however. Simple narratives about populist revolts rarely travel as well as the one about China, Brexit and Trump described above. Partly, that is because of differences in political traditions and electoral systems which only careful analysis can reveal. As we describe in our outlook on the European elections, populism from both the right and the left is not a new phenomenon in continental Europe. In many countries, the parties in question are decades-old. Some of them have already experienced several cycles of rapid electoral success, often followed by a swift collapse. Several had notable successes in the 2014 European elections. Both polling evidence and past experience suggest that outside Italy, the European elections of 2019 could actually prove fairly disappointing for yesteryear's populist winners. In part, this is because insurgencies against the status quo do not necessarily need to be extreme, nor eurosceptic. This is most obvious in countries like Poland. Overall, polling currently suggests that socially liberal, broadly pro-European and pro-market forces might actually do quite well.
All of which points to some broader lessons. Twenty-seven years ago, the political economist Francis Fukuyama famously proclaimed the "End of History." By that, he meant that there was no longer any ideological alternative to free markets and liberal democracy. In many countries, that era ended in 2016, if not before. Plenty of alternatives are emerging, often with dazzling speed. Political uncertainty is not some temporary aberration. It is a hallmark of what we would label the "Return of History." Ideological conflict is back, and understanding this new reality is likely to become an increasingly critical ingredient for investment performance. Instead of thinking: "This could never happen!", start thinking: "What could happen next?" And keep in mind that not all political surprises need necessarily be negative.
Political uncertainty is not merely a temporary aberration. Across many major democracies, voters appear understandably angry with the status quo.
Source: DWS Investment GmbH as of 02/2019