Higher interest rates and inflation are likely to make capital markets more volatile, says AllianceBernstein's Darren Williams – and politics could add fuel to the fire.
Among the most noteworthy political developments is the escalating battle between Russia and the UK over what appears to have been the attempted assassination of a former Soviet agent.
Domestic developments in China and Italy back up the message from the economic data.
That is, we’re heading for higher inflation and interest rates, which in the near term are likely to dampen the outlook for government bonds. Further down the road, they’re also likely to pose headwinds for risk assets, such as corporate bonds and equities.
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 last 20 years or so, the secular trend toward globalization has supported economic growth while keeping inflation low.
Major developments during that time helped power the march toward globalisation. Russia made attempts to move beyond the legacy of Soviet communism. China joined the global trading system.
And the European Union has moved toward greater economic and administrative integration.
Is globalisation 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.
So do allegations of Russian interference in the 2016 US presidential election. Australia’s support for the UK’s diplomatic retaliation against Russia is another case in point.
Recent developments in China are no less significant, with president Xi Jinping removing limits to his term in office.
Western commentators are divided: one camp sees the move as a dictatorial power grab; others see it as an 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, and 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.
While it remains to be seen what kind of government eventually emerges, the political mood within Italy seems to have shifted decisively against deeper integration. 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. And for evidence of the tangible impact of populism, look no further than US president Donald Trump’s resurrection of tariffs on steel and aluminium.
What does it mean for markets?
This leads us back to economics and monetary policy. Many growth indicators are at cyclical highs and many central banks are either starting 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 bites, it’s likely to act as a drag on economic growth and risk assets, too.
Darren Williams is the director of global economic research at AllianceBernstein.