Market concerns over European politics
Market volatility followed through from February into March. Politics continues to remain a source of uncertainty in Europe. In last month’s Italian general election, the anti-establishment Five Star Movement (FSM) emerged as the largest single party in parliament with a 35% share of seats in the lower house. FSM indicated that it wants to form a government in its own right, but it does not have a sufficient share of the parliamentary seats to form a government, so the next administration is likely to be a right-wing coalition formed around the Eurosceptic Lega (formerly the Northern League) and ex-PM Silvio Berlusconi’s Forza Italia. Although the Lega has toned down its rhetoric against the EU, the fact that a government from a founding member of the Treaty of Rome (the international agreement behind the creation of the pre-cursor to the EU), has talked about holding a referendum on Italy’s membership of the Eurozone is a tail-risk for markets.
Meanwhile, in Germany, a majority of SPD party members voted to enter a coalition government with the CDU/CSU in March. This secured Angela Merkel’s fourth term as Chancellor. Even so, the bitterly disappointing election result last September, and months of stalemate over forming a government, has come at a cost to the Chancellor. Ms Merkel’s party, the CDU, was forced to hand over control of the powerful Ministry of Finance to the SPD, the junior coalition member.
Moreover, her position as Chancellor, and leadership of the EU, may have been weakened at a vital stage in UK-EU Brexit negotiations. On that front, the UK has agreed a 21-month Brexit transition with the EU last month. Crucially, the EU has not made finalising a deal on the contentious Irish border issue a precondition for moving onto trade talks with the UK. Instead, what the EU wants is to discuss its future trade relationship with the UK simultaneously with efforts to resolve the Irish border problem. With the EU’s permission, the UK will be able to negotiate and sign trade deals with third parties during the transition period.
Market risks from US trade protectionism
Another source of market volatility is US trade protectionism. The White House has been purged of so-called “globalists”, like Rex Tillerson, the ex-Secretary of State, and Gary Cohn, the President’s chief economic advisor. It appears the trade hawks, such as Wilbur Ross (Secretary of Commerce) and Robert Lighthizer (the US trade Representative), may have more influence on the president. Under the likely new Secretary of State, Mike Pompeo, a hardline nationalist and hawk on China, in tune with President Trump’s “America First” agenda, US foreign policy may continue to be a source of heightened global trade frictions.
Indeed, following the imposition of higher import tariffs on washing machines and solar panels in January, President Trump announced higher tariffs on steel and aluminium US imports in early March. With an eye to the mid-term elections in November and on his own potential re-election in 2020, President Trump is pandering to his anti-trade support base in the rust-belt states to onshore jobs back to the US. It could also be that Trump is using his protectionism agenda as a signal to force other major trading nations, e.g. the Eurozone and Japan, to allow their currencies to appreciate against the US dollar. The hope is that this would reduce the US trade deficit and boost US competitiveness.
President Trump has since announced trade tariffs to tackle intellectual property rights that explicitly target China, which accounts for the bulk of the US trade deficit. Beijing has responded with measures of its own with tariffs on US exports to China. However, the measures announced by both sides are small economically; US tariffs account for 2.5% of annual Chinese global exports, while Chinese tariffs are less than 1% of US global exports. It is possible that President Trump’s protectionist agenda may actually lead to a constructive response from China, similar to trade pressure on Japan in the 1980s that forced the country to open up its market to foreign imported goods. Indeed, Chinese Premier Li Keqiang recently showed a willingness to open up China’s domestic market and enhance intellectual property. President Xi Jinping also offered $250bn in business deals with US companies during President Trump’s visit to Beijing last November. What will be critical for the markets is how economic and consumer sentiment holds up during these tit-for-tat trade protectionist measures.
While it remains to be seen if China and US are able to work out trade disagreements, at least trade tariffs are relatively low historically. Global economic growth is also broadening and US share buybacks are running at a record annualised pace of over $800bn. Beyond the short-term market volatility, that should give some succour to global risk assets.