Economic trends clearly point toward higher inflation and interest rates ahead, which will likely make capital markets more volatile. Based on recent headlines, politics seems likely to add fuel to this fire.
Rising inflation and interest rates will probably weigh on the near-term outlook for government bonds. Further down the road, they’re also likely to create headwinds for risk assets, including corporate bonds and equities.
As we see it, geopolitics could magnify the volatility. Among the most noteworthy developments is the escalating tension between Russia and the UK over Russia’s alleged attempt to assassinate a former Soviet agent on British soil. Domestic developments in China and Italy reinforce this notion. And if that wasn’t not enough to set alarm bells ringing, there’s now the intensifying US-China trade dispute to worry about.
Historical Context: Global Integration
To understand the significance of these political events for capital markets, it helps to think of them through the lens of globalization. Over the past 20 years or so, the secular trend toward globalization has supported economic growth and kept inflation low.
Major developments during this time helped power the march toward globalization. Russia made attempts to move beyond the legacy of Soviet communism. China joined the global trading system. And the European Union moved toward greater economic and administrative integration.
Is Globalization Past Its Peak?
Now, globalization appears to have peaked, and may be slipping into reverse. The perception that China, Russia and the West share similar aims and priorities has given way to a fresh appreciation of national political and cultural differences—and the resultant potential for disharmony.
While the Russia-UK uproar is unlikely to have any direct economic impact, it does serve as a reminder of the historical and diplomatic fault lines between Russia and the West, as do the allegations of Russian interference in the 2016 US presidential election.
Recent developments in China are no less significant, with President Xi Jinping removing limits to his term in office. Western commentators are divided. Some see the move as a dictatorial power grab; others see it as Xi’s attempt to create the stability he needs to enact further reforms. Whichever view is correct, China, like Russia, needs to be assessed more on its own terms than through a Western lens.
Fissures In The West, Too
The same applies to the West itself, particularly the European Union. The results of this month’s elections in Italy were untidy even by Italian standards. But they showed increased support for two parties―the anti-establishment Five Star Movement and the far-right Northern League.
It remains to be seen what kind of government eventually emerges in Italy, but the political mood within the country seems to have shifted decisively against deeper integration with Europe. And together with Brexit, it represents another crack in the foundations of European economic and political unity.
Like Brexit, the Italian election is part of a broader global theme: the rise of populism. For evidence of the tangible impact of populism, look no further than the US resurrecting tariffs on steel and aluminum—and announcing additional tariffs Thursday, rattling markets.
What Does This Mean for Markets?
This leads us back to economics and monetary policy. Growth indicators are at cyclical highs, and many central banks are either starting to raise, or about to start raising, interest rates from historic lows. Meanwhile, the risk that tightening global capacity will drive up wages and inflation is rising fast.
The outlook for capital markets is clear: political and economic trends are fueling the pressure for higher inflation, and with that higher interest rates. This is a clear negative for government bonds in the short to medium term. Eventually, as tighter monetary policy begins to bite, it’s likely to act as a drag on economic growth and risk assets.