Articles - An unholy trinity


The combination of low economic growth, loose monetary policy and rising political populism provides a framework for understanding both the drivers and the consequences of the UK’s vote to leave the European Union (EU). The same framework can be applied to impending referendums in Italy and Hungary, and to elections in Austria, France, Germany and the US. The message is clear: markets cannot ignore the risk of adverse political developments in any of these countries.

 By Paul Diggle, Aberdeen Asset Management
 The drivers of the UK’s vote to leave the EU were numerous, and the consequences of the vote are ongoing. It will be down to the historians to make a full assessment of both. For now, however, a working framework is provided by the trinity of growth, policy and populism:
  
 Low economic growth. UK real GDP growth has averaged 2.0% per annum in the six years since the financial crisis, well down on the 2.9% per annum achieved in the decade before the crisis. Real earnings growth has been negative on average in the years since the crisis, falling from above 2.5% per annum pre-crisis. Consumer confidence has also been depressed over this period. What economic growth there has been does not appear to have been evenly distributed across social classes and regions.
  
 Loose monetary policy. The policy response to low economic growth has been an extraordinary loosening in monetary policy by the Bank of England (BoE), in the form of low interest rates and quantitative easing. This has provided a backstop to the economy, averting worse growth outcomes. But the effect of stimulative monetary policy has been felt much more strongly in asset prices than in the real economy. The FTSE 250 equity index (more representative of the domestic UK economy than the FTSE 100) stands 34% above its pre-crisis peak, but the economy itself is just 7% larger over this time. Meanwhile, UK bond yields are at record lows, meaning that bond prices are elevated. This boost to asset prices has exacerbated the uneven distribution of post-crisis growth. Fiscal policy, which may have been able to engineer more inclusive economic growth, has taken a back seat in supporting the economy.
  
 Rising political populism. Taken together, the effects of low growth and loose monetary policy have created a sense of growing discontentment with the established economic and political order, and a search for answers outside the economic and political mainstream. One expression of this is the surge in the share of the popular vote for UK political parties other than the Conservatives, Labour and the Liberal Democrats, from a post-war average of 4.9% to some 24.8% at the 2015 general election. The referendum result itself is the most recent expression of anti-establishment sentiment.
  
 This framework also offers a guide to where the UK economy may be headed next.
  
 As the UK’s new relationship with the EU is negotiated, the impact of uncertainty is likely to weigh on the already subdued rate of economic growth. But further monetary policy support, as well as the depreciation in sterling, should provide a partial offset. With interest rates already low and space to loosen monetary policy limited, fiscal policy is also being used to support the economy. The (current) chancellor, George Osborne, has shelved his fiscal mandate to run a surplus by 2019/20 and announced plans to lower corporation tax. The expectation of policy loosening certainly appears to have supported the FTSE 250, which has pared back four-fifths of its initial post-referendum decline. In Scotland, meanwhile, popular discontentment with the referendum result has seen constitutional questions about membership of the United Kingdom come back onto the agenda.
  
 These forces are likely to play out again in a host of referenda and elections in Europe and the US over the next 18 months: a referendum on constitutional reform in Italy, a referendum on refugee quotas in Hungary, and the re-run of presidential elections in Austria, all in October; the US presidential election in November; and general elections in the Netherlands, France and Germany in 2017. Post-crisis GDP growth everywhere but Germany is lower than pre-crisis trends, loose monetary policy rather than fiscal stimulus has been the policy response of choice, and polls suggest populist sentiment is on the rise in each country.
  
 The most pressing concern is Italy. The referendum is on Prime Minister Matteo Renzi’s proposal to downgrade the role of the upper house of parliament, thereby removing an impediment to his efforts at much-needed structural reform. But Renzi has made the tactical error of tying his own political future to the outcome of the referendum – should he not secure approval for constitutional reform, he is likely to resign.
  
 The referendum therefore provides an outlet for populist anti-establishment sentiment, which has built in the face of Italian GDP growth that has been on average negative in the years since the crisis and a banking sector that is suffering under the weight of a large non-performing loan book and the negative interest rate policy of the European Central Bank.
  
 If the referendum results in Renzi’s resignation and a general election, there is a chance that the eurosceptic Five Star Movement, currently a close second behind Renzi’s Democratic Party in the opinion polls, forms the next government.
  
 The risk that Italy is ‘the next domino to fall’ cannot be dismissed.
  
 The growing success of populist politicians and causes in a number of advanced economies is not only a consequence of low economic growth and a policy response that has done more to boost asset prices than real economic activity, but also a barrier to the sorts of structural reforms that offer the best chance of boosting global economic growth. Whether or not populist politicians actually gain power, their influence is likely to be felt via a reorientation in political priorities away from painful but much-needed structural economic reforms, and towards policies that play well with domestic audiences.
  
 In southern European countries, that means exerting pressure on Brussels and Berlin to relieve fiscal targets. In northern and Eastern Europe, it probably means greater pushback on migration issues. And in the US, it may mean a rejection of the sort of free-trade agreements championed by earlier administrations.
  
 None of this speaks to the global economy pulling itself out of its current funk anytime soon; indeed, it only raises the already significant downside risks to global growth.
  

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