Investors, are you prepared for the economics of populism?

How will the rise of populism impact on economies and investors’ choices? Nikolaj Schmidt offers his view.

The resurgence of populism has reshaped global politics over the past few years, but what it means for economic growth and financial assets has yet to become clear.

Although markets are quick to respond to individual events, such as a populist party’s rise to power or the introduction of a tax cut or spending increase, they have yet to grasp how populist policies could affect the global economy over the long term.

This poses a challenge for investors, who need to understand the economics of populism to prepare effectively for the years ahead.

The key economic objective of populism is the redistribution of wealth and income from the elite to virtuous “ordinary” people. This is true for both right- and left-wing populists, although they disagree on who qualifies as “ordinary”.

To achieve redistribution, populists typically favour loose fiscal programmes combined with policies that challenge central bank independence, corporate governance and property rights.

Typically, this approach has resulted in negative economic outcomes, such as unsustainable fiscal deficits, high inflation and weaker currencies, which eventually lead to slower capital formation as business confidence ebbs.

While growth might initially be supported by some of these policies, it is likely to suffer over the longer term.

Economically, this picture resembles the US in the 1970s – a decade during which both inequality and profit margins fell meaningfully. The economic policies of the period were characterised by a combination of price controls to limit inflation and expansionary fiscal policies to support real income growth, enacted against a backdrop of shocks from rising oil prices.

These policies caused equity markets to rise well below inflation, nominal bond yields to rise, while real yields fell and the dollar depreciated against other major currencies.

Pressure on central banks to adopt accommodative monetary policies will typically lead to increased inflation expectations, steeper yield curves, lower real yields, and currency depreciation.

At the same time, the push for income redistribution and higher wages reduces profit margins, which, in combination with rising macro uncertainty, challenges equity valuations.

Both sovereign and corporate credit spreads can be expected to widen when governments undertake fiscal expansion amid a backdrop of limited fiscal space.

The early signs of this can be seen in President Donald Trump’s deficitfinanced tax cuts and the ruling Italian populist coalition’s battles with the European Union to push through an expansionary budget.

Asset allocation

Faced with loose fiscal policies and reduced property rights, investors in countries ruled by populist leaders are likely to turn to inflation-linked bonds, real assets and gold, which may perform well during periods of rising uncertainty and heightened inflation.

Investors are also likely to avoid the currencies of populist-ruled countries, boosting the currencies of those countries with more mainstream governments.

It is unlikely that the current generation of populist politicians will deliver the income redistribution and social mobility their base demands.

Jobs that have been outsourced to other countries cannot easily be repatriated, and excessively loose fiscal policies invariably have outcomes that dent business confidence and reduce capital formation and job creation, i.e. the initiatives are a drag on growth, which probably makes income redistribution and social mobility harder to deliver.

But it would be a mistake to think that the potential failure of populist politicians will lead to the early demise of populist politics. Voter demands for greater equality and social mobility will not be silenced – and if the first populist government voted into power fails to deliver, voters are more likely to elect another populist candidate than to vote for mainstream candidates.

We should therefore not regard the elections of Donald Trump in the US, Viktor Orbán in Hungary, Andrés Manuel López Obrador in Mexico, Jair Bolsonaro in Brazil, and the populist coalition in Italy as isolated events; rather, they are likely to be the first in a string of such victories.

It is not only populist “alternative” candidates who promise greater equality and mobility; incumbent politicians are likely to shift their stances to address the populist threat.

To keep populist politicians from power, mainstream parties will find they must offer a viable alternative, that is, centreright parties must shift further right, and centreleft parties must shift further left.

In this way, populist movements can exert considerable influence over policy without actually gaining power.

It is important for markets to embrace the possibility that the populist movement is a longterm, structural phenomenon, and if it is, I believe that it will have long-term, mainly negative, economic outcomes.

Nikolaj Schmidt is chief international economist at T. Rowe Price.

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