Financial markets are very bad at evaluating political risk. They assume people will always be rational, and expect a ‘business as usual’ scenario to continue. But as we all know, people are not always rational. And emotion, as today over immigration may cloud their judgement.
This week has seen the first signs of this complacency changing. The pound fell to a 7-year low versus the dollar, back at levels last seen at the start of the financial crisis, after premier David Cameron said the UK would hold a referendum on 23 June on whether to leave the European Union.
The cause was an online poll showing a narrow majority for the Leave vote, although conventional polling shows a majority for the In campaign.
Does this matter, you may ask? It certainly could, if you look at the chart above from the Economist, showing public debt as a percentage of GDP. The UK is up towards the top of scale, thanks to stimulus spending, with debt between 80-99% of GDP:
- Much of this debt is financed by foreign lenders, who bought it on the basis that the UK was politically stable and a long-term EU member
- Now they have to live through 4 months of potentially conflicting poll results until the referendum
- They could easily be forgiven for thinking they might have fewer sleepless nights if they switch to US Treasuries
What could this mean for the UK economy? History suggests that the Bank of England will be forced to raise interest rates to defend the value of the pound. ”But that’s impossible today”, you might reply. ”The Governor of the Bank of England is said to be considering negative interest rates, not raising them”.
This is the key issue. What the financial markets expect, and what politics may cause to happen, could – and I use the word “could” – be quite different. Suppose, just as a Scenario, polls continue to suggest the Leave vote might win, and the pound does fall further by May. Then the Governor will be between a rock and a hard place:
- If he leaves interest rates at low levels, bad poll numbers before the referendum might cause the pound to plunge
- If he raises them to defend the pound, then voters might panic about the impact on house prices
- Either outcome would very probably boost the Leave campaign, creating a vicious circle
This, of course, is only 1 Scenario. But as we have seen in the Scottish referendum, and more recently in the US primaries, voters are proving to be very volatile in their opinions. Scotland only stayed in the UK by a narrow margin, and very few people, a year ago, would have thought Donald Trump could be the Republican candidate – or that Bernie Sanders could prove an effective opponent to Hillary Clinton.
So bear with me a moment, whilst I extend the Scenario. Suppose the UK did vote to leave – would the EU survive in its current form?
Italian premier Matteo Renzi has warned that “The EU is like the orchestra playing on the Titanic“. And there are no signs that the border controls introduced over the past year will be removed soon – threatening the Schengen Agreement and the Single Market – as I discussed in my BBC interview last year – and therefore the survival of the euro. Meanwhile the anti-EU National Front is leading the polls for next year’s French presidential poll.
So would foreign investors look at EU debt, and start to think they might have fewer sleepless nights if they sold out?
And if they did, would Mario Draghi at the European Central Bank also have to suddenly increase rates to defend the value of the euro, and protect the bond markets? Spain, Portugal, Italy and Belgium all have debt/GDP ratios of over 100% – and France, Austria at Ireland have similar levels to the UK. Greece has high debt levels, and has shouldered the refugee burden – causing a further rift with the EU.
And what would be the political reaction if he did have to do this? Or, indeed, what would be the bond investors reaction if he did nothing?
This is the problem created by the lack of leadership shown by Europe’s political elite. They refused to have the difficult, but necessary, dialogue with the electorate about the impact of ageing populations on the economy (median age in Italy and Germany is already 46 years). Instead, they have allowed the central banks to provide a fig-leaf to cover up the problem with their ever-increasing stimulus programmes.
We can certainly hope, and I certainly hope, that the UK votes to stay In by a substantial majority. But hope is not a strategy. And if financial markets find themselves suddenly having to catch up with political events in Q2, it is always helpful to have done some scenario planning beforehand – before everyone else begins to panic.