Three market concerns move to the fore

Last week brought renewed focus to three areas of concern that I’ve been writing about for some time: populism, protectionism and pressure on debtors. It appears that we may be moving closer to certain outcomes that could be of concern to markets.

Populism

On March 4, Italian citizens will vote in the country’s parliamentary elections. With polls showing there are still many undecided voters, there is much uncertainty surrounding the election. It seems likely that the Five Star Movement – a relatively new party focused on environmental, anti-immigration and Euroskeptic issues – could garner the most votes of any party, although not enough to govern without a coalition. However, the Five Star Movement, which is seen as populist in nature, has in the past ruled out forming coalitions with other parties, which means that we might see the formation of a different governing coalition involving Silvio Berlusconi’s right-wing Forza Italia party and the very-right-wing, populist Lega Nord party. In other words, the most likely outcomes could result in an anti-European Union (EU), populist movement in Italy’s leadership – a significant departure from the past several years in which Italy was governed by a center-left coalition that was largely supportive of the EU. This situation is further complicated by the reported involvement of “bots” – automated social media accounts such as fake Twitter profiles – that are attempting to help populists win the Italian elections.¹ This is particularly troubling given that the U.S. Senate warned last month that Italy is a potential target for Russian election manipulation.

What’s so worrisome about a populist regime in power? While it’s unlikely that we will see an “Italexit,” it is likely that such leadership will make it more difficult for the EU to become more politically and fiscally aligned – which is part of French president Emmanuel Macron’s vision for reforming and improving the EU. In addition, populism could result in efforts to erect protectionist barriers. Which brings us to our next topic.

Protectionism

Last month, we saw the U.S. impose tariffs on two imports from China – washing machines and solar panels. The move seemed small in scope, but at the time I worried that it could result in retaliatory actions on the part of trading partners, given that tariffs tend to beget more tariffs. But despite strong words, there was no retaliation, at least not yet. Then, last week, America’s protectionist stance gained momentum as the U.S. Commerce Department recommended significant barriers on steel and aluminum imports to the U.S. This all started back in April, when an investigation was opened under Article 232 to determine whether these imports posed a threat to the country’s national security. The report released last week by the Commerce Department concluded that such imports are weakening the country’s internal economy, and therefore pose a threat to U.S. national security.

The recommended solution was essentially a cafeteria list of different options, comprising quotas or tariffs or both, which could be waged against all countries or a select group of countries. In other words, President Donald Trump could determine that specific countries should be exempted from the proposed quota, or that only a few countries should have tariffs imposed on their goods. Those tariffs would be determined by the economic or security interests of the United States – a relatively amorphous standard. In making a determination on which countries would be subject to tariffs or quotas, Trump could consider the countries’ willingness to work with the U.S. to address issues such as global excess capacity and other challenges facing its aluminum and steel industries. For its part, the Aluminum Association advocated focusing specifically on Chinese overcapacity while “avoiding unintended consequences for U.S. production and jobs.”

Not surprisingly, after the release of the Commerce Department’s recommendation, China announced that it reserves the right to retaliate if tariffs and/or quotas are imposed. In addition, a number of groups have come out in opposition to such trade barriers, including beverage companies and auto manufacturers. Some Republican lawmakers have also voiced opposition to these protectionist proposals, saying they would jeopardize U.S. manufacturing jobs. It seems likely that input costs would increase if the Commerce Department’s recommendations were enacted, which is why stocks of U.S. auto makers fell after the news on February 16.

President Trump has 90 days to review the findings and recommendations and make a decision; we will want to follow the situation closely. As I have mentioned, geopolitical risk rarely impacts capital markets in a material way over the longer term – but protectionism can and typically does. Keep in mind that higher inflation is often a result of protectionism, which means that protectionism might be one of many forces pushing prices higher. And that brings us to pressure.

Pressure

Last week, stocks made a dramatic recovery, retracing nearly half the loss made in the “flash correction” of the previous week. That correction was brought on by concerns about higher inflation, which could trigger higher interest rates – and indeed the 10-year Treasury yield did rise significantly over the past several weeks. However, while stocks have shrugged off concerns about higher rates – at least for now – we need to remain focused on them. That’s because inflationary pressures seem likely to be building, which could result in higher rates that place potential pressure on governments, companies and households.

The Federal Reserve Bank of New York just released data showing that household debt in the U.S. is at an all-time high of $13.15 trillion after five consecutive years of growth.² In Canada, household debt has risen to 101.15% of gross domestic product (GDP)³, while in Switzerland it is 127.5% of GDP.⁴ In South Korea, the ratio of household debt to GDP is 93.8%.⁴ Rising debt is problematic because it impacts economic growth; recent research has shown that a 1 percentage point increase in the household debt-to-GDP ratio is associated with growth that is 0.1 percentage point lower in the long run.⁵

Keep in mind that debt service is not just about the amount of debt; it’s also about the interest rate. Not only are we taking on more debt in many parts of the world, but interest rates are going up in certain regions as well (which can be especially problematic for countries in which mortgages are predominantly variable-rate as opposed to fixed-rate). That means more money needs to be spent servicing that debt – money that could be put toward more productive purposes such as capital investment. Even if rates go up gradually, they can place significant pressure on debtors – an important issue we will have to follow closely.

Key takeaways

For some time, I’ve written about the “three D’s” – disruption, divergence and demographics/debt – which are three macro themes that can impact markets and investors. Now, add to that the “three P’s” above. With so many global forces applying pressure to markets, investors are understandably concerned. But it’s important to remember the “ABC’s” of investing – allocating to a diverse range of investments, being disciplined, and creating a long-term plan.

In particular, I would note:

• We can’t ignore the specter of higher inflation. This means considering the potential benefits of inflation-hedging investments, including commodities, real estate investment trusts, gold and inflation-linked bonds.
• While volatility has hit markets around the world, valuations are relatively lower in many markets outside the U.S.
• Alternative investments may react differently than stocks and bonds to market moves.

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