Continued market optimism in the face of political uncertainty may surprise some, but is explainable. We generally still have faith in the ability of institutions to pull us through any future difficulties. But such problems are never entirely predictable.
1. There are good reasons why markets have remained buoyant, despite President Trump’s travails.
Markets have remained generally buoyant this week, despite elevated levels of political uncertainty, particularly around the U.S. presidency. There are good reasons for the markets’ continued optimism: on the back of an excellent U.S. Q2 earnings season, U.S. economic data has remained generally positive. It is also possible to argue, as we do on page 2, that whatever his personal fate, President Trump’s economic reforms are firmly in place, with few more initiatives expected in the next few months anyway. The ongoing visit of a Chinese delegation to Washington has also raised hopes that both countries accept that a full-scale trade war would be very damaging, and will do what is necessary to avoid it.
2. One core source of support is a belief in the continuity and independence of key institutions.
U.S. market optimism also may have much to do with a belief in the continuity and independence of the country’s institutions. Because of this, very few believe that President Trump’s recent criticism of Fed Chair Powell will lead to a change in Fed tightening policy. In a rather different way, there is also an assumption that the long-term focus of the Chinese government will allow it to engineer a “soft landing” for the Chinese economy (page 5), although observers will be looking for signs of dissension between policymakers. There may also be a market realisation that, nearly a decade into the Eurozone debt crisis, the EU institutions have proved a tougher nut to crack than many had expected.
3. Policymakers will be careful not to trigger a reversal through policy error – but expect the unexpected.
What would it take to reverse current optimism and pitch the markets into a state of gloom? Crises can often start with complacency, overreach or simple error. Policymakers are well aware of this. As a result, while some Italian politicians may want to force a confrontation with the EU over the budget plans, EU institutions are likely to be extremely careful in their response: they will not want to provoke a crisis by being seen to overreach themselves. Within Europe it is perhaps ironic that the UK, a country with an unrivalled record for institutional continuity, now seems most at risk of complacency or policy error, with the Brexit outcome still frustratingly unclear. But remember too that crises can often start with the unexpected – perhaps the result of markets turning a blind eye to issues that, in retrospect, seem obviously dangerous. Recent emerging market problems, for example around Turkey, remind us that there could be many future causes of volatility. So stay invested, but hedge.
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