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The rise of populist politics could lead to protectionism and recession, so make sure your portfolio won’t be found wanting if tough times arrive
September 2, 2016

Populism and your portfolio

Let me reassure readers, this is not yet another article on Brexit, although some of the more pessimistic narratives employed by the Remain side are central. Rather, the focus is on underlying forces of populism which have found their expression in the UK’s vote to leave the European Union and are observed in various guises around the world. Most notable is the spectacle of Donald Trump running for American president and there is also a prominent coterie of reactionary parties (too significant to be dismissed as mere protest movements) in France, Austria, Italy and the Netherlands.

In our office building, shared with the staunchly pro-EU Financial Times, there was a palpable sense of disbelief, dismay and even anger the day of the UK result. Our sister publication has since been attacked by those in the right-wing press who are galled by the FT’s “Remain continuity campaign” – reporting that is supposedly overly negative about Britain’s prospects outside the European bloc. The FT has also been a vocal critic of Trump; in part justifiably given some of his unpleasant xenophobic, Islamophobic and chauvinistic utterances. While many of a liberal mind-set feel an instinctive revulsion to aspects of Trump’s rhetoric, the idea ordinary people have been left behind is less controversial. Increasingly, as the political focus of the Financial Times reflects, those at the head of supranational government and financial institutions – who have driven and profited most from globalisation - are now fearful of the populist backlash.

At Investors Chronicle we strive to be apolitical in our outlook but it is only circumspect to examine some of the ugly scenarios should an economic fallout from populism come to pass. Recently, as part of their global stress test series, index provider MSCI took a detailed look at populist movements and potential negative consequences for investors and we explore portfolio allocations to be ready for political uncertainty.

What are the causes of populism?

In one of the most memorable scenes in the Regency period Blackadder III, butler Edmund is explaining the cause of civil unrest to Prince George (as he gorges on a rather large Melton Mowbray):

“The world is crying out for peace, freedom and a few less fat bastards eating all the pie!”

This perspective from the writers of a 1980s comedy show is typical of a left-wing explanation of popular discontent. The MSCI report offers a more politically neutral view:

“Populist movements have appeal when the economic pie is not growing, it is being divided unevenly and there is a perception that outsiders are competing unfairly for what remains.”

Taking this point by point, firstly it is no secret that GDP growth has been more sluggish coming out of the Great Recession which followed the 2008 financial crisis, than it has exiting previous downturns. Globally, annualised GDP growth 2009-14 lagged the figure for the 1986-2007 period by some distance, with growth particularly unimpressive in the European Union.

Secondly, the benefits of globalisation have accrued primarily to emerging markets and the often maligned top 1 per cent of the income distribution in developed markets. As the chart shows, those in the bottom half of income distribution in the USA and Europe have actually experienced below average growth in income. A growing pay gap between work forces and executives is to be seen across the board, fuelling a sense of injustice.

The third point focusses on the incendiary issue of immigration. The basis in fact may be highly contestable but the UK referendum demonstrated many voters’ perception of immigrants as competitors for scarce economic opportunities and an additional burden on stretched public services.

Populist policies and how they could hurt the economy

Curbing immigration, unsurprisingly tops the list of right-wing populist policies. Given the considerable positive effects studies have shown immigration to have on GDP, policies to curb it will come with economic disadvantages. This is even more the case for the UK, as European leaders are unlikely to drop acceptance of free movement as a core condition for access to the single market.

The focus of the left is more on redistribution of wealth and the improvement of public services. These are noble goals but, unaccompanied by sustainable growth and wealth creation, the fear is such policies will ultimately prove inflationary. Interestingly, many commentators are calling for fiscal expansion as a way to stimulate growth, although they are referring specifically to capital infrastructure projects rather than redistribution of wealth.

In some areas, there is a convergence of opinion between left and right, with voices across the political spectrum arguing for the reverse of some trade deals that have been cornerstones of globalisation. Supporters of Donald Trump believe that US participation in some world trade deals has given a raw deal to US workers. In Europe there is concern that proposed agreements, such as the Transatlantic Trade and Investment Partnership (TIPP) will put public services such as the NHS at the mercy of some of the more rapacious aspects of capitalism.

The conundrum, however, is that liberalisation of trade is seen as a key ingredient in generating economic growth. Ben Bernanke, the former Chair of the Federal Reserve, often stressed that protectionism was one of the reasons the Great Depression was so severe. He may be right but the political and financial elites have a credibility problem with the populations who have lost out from globalisation. Mr Bernanke is about as establishment as it gets so, as part of the club which failed to ensure an equitable sharing of the costs and benefits of globalisation in the past, many ordinary voters are likely to ignore voices like his.

The upshot is that populist political movements could, if in power, unleash a spate of protectionist economic policies which choke off economic growth. For investors in shares, this is bad news, as GDP remains the main driver of equity returns. In their report, MSCI looked at trying to quantify the effect of recessionary and even a stagflation scenario, on core asset classes.

MSCI’s two core stress test models

The distinction needs to be drawn between “Project Fear” style warnings that are designed by political spin doctors (and seem to be failing) to influence voters; and models of adverse outcomes intended to help investors plan portfolio allocations. As MSCI Global Head of Research, Remy Briand puts it; “Stress tests are not forecasts, they are scenarios that could occur, to help answer the question: ‘Are you prepared or not?’”

So what should investors be prepared for? MSCI built two models as part of a study last month. One looked at the potential effects of ‘Brexit contagion’ – a spill over from the UK vote that leads to the break-up of the eurozone – and the other focussing more generally on the implementation of populist policies across advanced economies in Europe and the US.

The Brexit contagion scenario rests on forthcoming events, such as the Italian constitutional referendum or next year’s French presidential elections, opening the doors to populist parties keen to regain national sovereignty and potentially break-up the eurozone. If anti-establishment voices were to win, MSCI estimate a 3.8 per cent decline in eurozone GDP, an 18 per cent crash in equity markets and a rise of 229 basis points for Italian 10-year Treasury bond yields. There could also be a fall-out for UK investors, having already assumed Britain’s economy will decline due to Brexit uncertainty, the model has the contraction worsening to 4.3 per cent and London equities falling by 22.4 per cent.

MSCI acknowledges assumptions need to be continuously refined and certainly the strength of the UK stock market rally since the referendum will have confounded some pessimists. Reiterating that the purpose of stress tests is to focus on potential downside, there is a value in thinking about what a really bad outcome might look like even if reality turns out to be more benign.

The second scenario looks at popular moves to reverse globalisation. If protectionist policies gain enough influence and traction to reduce trade between countries, then growth will inevitably suffer. To compound matters, populist movements often demand governments spend more money at a time when tax revenues are falling. Such expenditure can only be funded by borrowing and MSCI highlight the risk inflation could surge if investors perceive the increase in government debt to be unsustainable. Combined with recessionary pressures, this points to a stagflation scenario where a 3 per cent annual GDP contraction in Europe and the USA coincides with 3 per cent inflation and 18 and 20 per cent falls in US and European equities, respectively.

How are estimates of stress outcomes made?

Models that pinpoint scenarios to within one decimal point are, to be honest, a bit far-fetched but a logical process is used to arrive at estimates. For example, when assessing the potential impact of protectionism, MSCI take the benefits of globalisation to GDP – roughly 3 per cent a year – and put this into reverse to model for a protectionist scenario (ie, assume a 3 per cent annual contraction). They then look at the typical reaction of equities and bonds to a 3 per cent annualised fall in GDP to estimate the effect on portfolios. Mr Briand explained that the team: “Looked at academic studies and past data to see what the previous impact of 3 per cent GDP contraction has been on asset prices.”

Figures should not be taken literally but they are a useful guide for investors wanting to assess the robustness of their portfolios. The bar chart shows how the two stress scenarios would be expected to affect various asset allocations. The key difference between the Brexit contagion, and populist protectionism and debt expansion, is the inflationary effects anticipated in the latter case. In the broader populism case study, fixed income strategies are expected to do badly thanks to the stagflation scenario.

In the portfolio allocations MSCI set out, models with greater tilts towards sovereign debt are expected to provide protection in the event of a Brexit contagion shock to growth strategies. In the wider rise of populism scenario, when inflation is factored in, sovereign debt is not expected to offer the same solace. Of course, these portfolio tilts are only meant to be illustrative and are not investment suggestions.

Mixed outlook for styles and sectors

While the stress tests are not intended as signals to invest, they are a useful guide on which investing styles could underperform in given scenarios. In addition, the tests indicate how different stock market sectors are likely to fare.

For cyclical sectors that are most sensitive to wider economic growth, the outlook is particularly awful. Financials could suffer especially too, as banks may well become the focus of populist governments’ economic policies. Industrials might see the effects of weaker international trade partially mitigated by increased government expenditure on infrastructure. In a sinister echo of the 1930s, defence spending is also cited as one area that could boost the industrial sector. Defensive sectors are expected to do least badly.

Looking at broad investing styles, small cap and value strategies underperform relatively, with quality and minimum volatility styles holding up better.

How to strengthen your portfolio

It is worth repeating one more time that the populism stress test is one example of a range of scenarios investors should consider and the MSCI report notes there is uncertainty about how economic, political and market risks may unfold over time. For investors who are especially concerned with the possibility of a new wave of populist policies, and believe that the outcome could be not only recession but stagflation, there are some takeaways for portfolio design.

For fixed-income allocations inflation-protected government securities provide weak returns but could be used to preserve capital. The danger of stagflation can be mitigated with some allocation towards gold. In the 1970s, with equities in the doldrums, the yellow metal enjoyed a phenomenal bull run and, although it offers no income, gold’s enduring ability to act as a store of value can give investors succour in testing times.

With equity allocations, a bias towards defensive stocks has been proven to outperform the market over time and this again would be a sensible ploy to guard against the populism scenario. Industrial stocks best placed to benefit from government expenditure on infrastructure and defence are also an option.

When there are question marks over general economic stability, it is also worth screening for the quality factors that indicate which companies are placed to achieve some growth and pay dividends. The indicators to look out for include return on equity (R0E) which measures how much profit management is returning on shareholders’ funds; earnings stability; the level of operational gearing a firm has (ie, how well it covers fixed costs out of operating profit); debt to equity (the claims of debt-holders are a risk to shareholders’ dividends) and debt to earnings; and share price relative to free cash flow per share (PFCF). Screening the FTSE 100, high rankers on some of these criteria include Hargreaves Lansdown (HL.), Persimmon (PSN), Admiral (ADM) and Burberry (BRBY). A populist and protectionist scenario would undoubtedly provide particular headwinds and issues for individual companies. A way to diversify across sectors and internationally is to use a quality factor exchange traded fund (ETF) for some equity allocation.

For investors looking for income, there are safe dividend criteria that can be followed, a good example being the screen used by Liberum Capital in the run-up to the UK’s EU referendum. This also took account of quality factors with a tilt towards income, including dividend cover and the standard deviation of earnings per share (EPS) and dividend per share (DPS). Again, there are ETFs available targeting both quality and income factors.

The simple portfolio put together here using ETFs is not ruled by the fear of bad possible outcomes from populism. After all, optimism is at the heart of investing but the allocations reflect a desire to be ready should the political outlook act as a drag on the global economy. The portfolio is not especially conservative with 55 per cent overall in equities. Breaking down the exposure of the ETFs there is a bias towards the UK and US markets (roughly a fifth of the total portfolio each) reflecting their representation in the MSCI Quality and Minimum Volatility indices, as well as the UK dividend ETF. Fifteen per cent in rest of the world equities still gives an opportunity to profit if growth is stronger in other regions.

Fixed-income investments are split between index-linked UK government bonds and investment grade UK corporate debt. There could be scope for capital gains in the corporate bond space as the Bank of England’s asset buying programme may be broadened in scope and the ‘linkers’ are a good way to protect against inflation, with a low risk to principle. Gold exposure is included in case populist policies create an environment conducive to stagflation.

Investors may prefer to pick individual companies but the drawback of screening for a particular set of circumstances is the potential to become granular, increasing exposure to idiosyncratic risks. The hope, therefore, must

be that policy makers can find a way to stimulate economic growth to broaden the opportunity set of attractive investments. Low global growth since the financial crisis is evidence a fresh approach is needed and weak productivity can be interpreted as inequality (which is arguably at the root of populism) also hurting the economy. A more inclusive recovery may be part of the solution but so is trade and it is imperative these two needs are reconciled. The harsh judgement is that, so far, the establishment has failed and the worry is protectionist policies will make the situation worse.

 

Factors fuelling the rise of populism in The West

In one of the memorable scenes in the Regency period Blackadder III, butler Edmund is explaining the cause of civil unrest to Prince George (as he gorges on a rather large Melton Mowbray):

“The world is crying out for peace, freedom and a few less fat bastards eating all the pie!”

This perspective from the writers of a 1980s comedy show is typical of a left-wing explanation of popular discontent. The MSCI report offers a more politically neutral view:

“Populist movements have appeal when the economic pie is not growing, it is being divided unevenly and there is a perception that outsiders are competing unfairly for what remains.”

Taking this point by point, firstly it is no secret that GDP growth has been more sluggish coming out of the Great Recession which followed the 2008 financial crisis, than it has exiting previous downturns. Globally, annualised GDP growth 2009-14 lagged the figure for the 1986-2007 period by some distance, with growth particularly unimpressive in the European Union.

Secondly, the benefits of globalisation have accrued primarily to emerging markets and the often maligned top 1 per cent of the income distribution in developed markets. Those in the bottom half of income distribution in the USA and Europe have actually experienced below average growth in income. A growing pay gap between work forces and executives is to be seen across the board, fuelling a sense of injustice amongst electorates.

The debate on fiscal expansion

The austerity programmes began in the early 2010s drew the ire of the left who argued that the most vulnerable in society were unfairly bearing the greatest burden of a financial crisis they did nothing to create. Yet there are now voices from the corporate and investment banking worlds also calling for fiscal expansion to help boost growth.

Not all fiscal expansion is created equal however. Morgan Stanley Research in their Global Macro Summer Outlook argue that an aggressive fiscal policy response in developed markets is critical to boosting growth. Unlike the supporters of populist leftist movements, they are very much referring to capital projects and investment that will have a demonstrable pay-back (in the immediately financial sense), rather than policies to increase the share of wealth amongst the poorer members of society.

Given the trouble governments have had in boosting inflation over the past few years, the use of fiscal policy is not going to have a crowding out effect on economic investment. The stagflation situation from the MSCI stress test model seems unlikely on the back of increased and targeted capital infrastructure spending by the state. As economists of all political hues are calling for this kind of fiscal intervention to boost growth, it will be difficult to simultaneously argue the inflationary dangers of wealth redistribution. Indeed, if firms gain big state contracts while spending on services is cut, allegations of crony capitalism may only fuel populist anger.