It’s not over yet!

While governments are striving to tackle key trade, fiscal and political challenges, investors still need to be braced for further tension ahead.

After a tumultuous time for global politics in 2018, economic and financial pressures appear to have improved the outlook for 2019 somewhat. The US and China restarted trade negotiations, with Chinese action on autos and soybeans signalling a willingness to engage. Meanwhile, Italy’s populist government agreed to reduce the country’s deficit to just above 2 per cent, and in the UK Theresa May’s government survived a no-confidence vote in early January over its failure to pass its Brexit deal through Parliament.

However, rather than resolving problems these developments may just have delayed the crunch points. Accordingly, a resumption of political tensions cannot be ruled out as 2019 progresses. From global trade tensions to further Brexit uncertainty, Stephanie Kelly, Political Economist at Aberdeen Standard Investments, examines the factors likely to lead to another bumpy ride for investors in 2019.

US-China trade tensions continue

Let’s take the US-China trade war first. The Buenos Aires détente, established on the last day of November, gives the two countries a 90-day period to strike a trade deal. But we don’t think that this temporary truce will lead to any lasting resolution of the conflicts over forced technology transfers, intellectual-property protection and non-tariff barriers. Therefore, we expect those tensions to return when that period ends and, as things stand, the US is set to raise tariffs in March. We will be watching negotiations carefully, however, for signs of willingness on either side to defuse tensions further.

China has demonstrated some goodwill by lowering auto tariffs and increasing soybean imports. But deeper structural changes to the Chinese economic model would be required to resolve the non-tariff issues. And Sino-US tensions extend well beyond trade and into geopolitics and technology security – as the recent Huawei dispute shows. This makes compromise harder to achieve. On the US side, the Democratic majority in the House means that President Trump is likely to face more political challenges in 2019. He may also have to contend with a tougher economic environment. A sharp deterioration here could make him less likely to impose additional tariffs on Chinese goods.

Italy battles budget deficit

What about Italy? The League/M5S coalition government has revised down its planned budget deficit from 2.4 per cent to 2.04 per cent. But we remain sceptical of Italy’s fiscal estimates. We also have doubts over the longevity of the truces between Italy’s coalition partners and between the Italian  government and the European Commission. The truce with the European Commission reflects a climb-down by M5S leader Di Maio, as his party’s relative power has declined. These dynamics may put stress on the coalition in 2019; an emboldened League is probably biding its time to call fresh elections and capitalise on its strength. If the League maintains its recent more moderate, pro-business stance, a League government, perhaps in coalition with a centre-right party, is likely to be less problematic for markets than the current coalition. Elections can bring surprises, however, as the UK demonstrated in 2017.

Meanwhile, we think it is unlikely that Italy’s specific budget target will be reached. Details on how it is to be achieved are scant, and the embedded revenue estimates are probably still too ambitious. Moreover, the European Commission is less concerned with the headline budget deficit and more with the structural deficit and debt-to-GDP dynamics. These still look unstable. So, while the immediate tensions have lessened, we think that problems are likely to bubble up again in the coming months.

Brexit uncertainty weighs on UK In the UK. Deep divisions in the Conservative party continue to challenge the ability of any leader to get a deal through Parliament. The EU’s reluctance to renegotiate illustrates its rules-based approach. So we expect any changes from the EU side to be cosmetic rather than substantive.

But Conservative Brexiteers may still think twice about opposing May’s plan when it returns to the Commons. Their main concern should be the risk of fatally injuring the government, as a general election could lead to a version of Brexit with which they are even less happy. Additionally, market stress may rise if ‘no deal’ contingency planning raises concerns about a chaotic Brexit; in so doing, focusing minds. The momentum for a second referendum has accelerated in recent months and throws yet another source of uncertainty on the pile.

Further EU integration stalls

Brexit is far from the only challenge that Europe faces in 2019. Last year, there was optimism that a Macron-Merkel-led coalition could advance the next stage of EU integration. We were sceptical, given the challenging sovereign political environment. Recent events have reinforced our view that integration in the eurozone and EU on fiscal and financial burden sharing will struggle to gain traction.

German politics is in flux as allegiances are redrawn. The CDU-CSU is uncertain of where the centre-right ground should sit while the SPD faces challenges from the left and in particular the Greens. However, the evolving political landscape in Germany does not alter the Brexit outlook as the EU rules-based approach continues to dominate. Nor does it alter the outlook for risk sharing in Europe more broadly as German politics continue to propose risk reduction before risk sharing.

Recently, French politics has been dominated by the gilets jaunes or ‘yellow vest’ protests. These were sparked by the intended imposition of a carbon tax but expanded to encapsulate public unhappiness with President Macron’s reforms and personality. The implications of these protests are, for now, limited. Macron’s La République En Marche party and coalition partners Democratic Movement hold a very large majority in the French lower house of parliament: 350 of 577 total seats. The French system makes removing a president difficult, particularly given these numbers. The main impact of the protests may be simply to slow the progress of Macron’s reforms. Given the fresh French fiscal expansion entailed by Macron’s concessions to the protestors, comparisons are inevitably made with Italy. The EU’s Commissioner Moscovici has been keen to stress that the two countries’ balance sheets are very different. But the French developments may incentivise the Commission to delay challenging Italy until later in 2019.

Populist momentum persists

And finally, what about elections? A UK general election remains a wild card. Though the European elections did not deliver the huge gains for populists some predicted, their rise is still a concern for many. However, investors should remember that European far-left and far-right populists have very different preferences regarding fiscal rules, risk sharing and eurozone integration. So we expect continuing stasis on institutional reforms.

Overall then, investors should remain cautious of political risks in 2019. Last year’s tumult may be behind us, but the current calm may just be the lull before the next round of storms.

 

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