This may go down as the year it didn’t happen.
Britain looks increasingly unlikely to leave the European Union; the wheels are coming off Donald Trump’s comic opera quest for the presidency; and the Federal Reserve may prove simply unable to raise the price of credit.
Investors are pleased with all three, in varying degrees, with growing conviction that Britain will vote to stay in the EU particularly helping to underwrite a recent rally in riskier assets worldwide.
All of this of course is another way of saying that investors may alternatively face a crumbling European Union, tightening monetary policy and a joker in the White House.
Yet given recent developments, and some realistic alternative scenarios, an ongoing relief rally may be in the cards.
Beginning with the murder of British MP Jo Cox, financial exchanges, betting markets and polls have sharply changed trend and are now strongly indicating a growing probability that the UK will choose to remain in the EU at its Thursday vote. Having digested polls released since Cox died, betting exchange Betfair on Monday put the implied probability of a vote to remain at 72%, up from 60% before the assault.
A vote to leave the EU would be both deeply unsettling for financial markets and likely to send riskier assets sharply lower. Not only would a political fracture hurt the British economy, it might lead to the further dissolution of the EU itself and signal a new tide pushing against globalization.
Donald Trump, the likely Republican presidential nominee, is also losing round rapidly in polls and on Monday fired his campaign manager. Having been neck-and-neck with likely opponent Hillary Clinton as recently as May 24, Trump is now a full 6 percentage points behind, according to an average of polls by Real Clear Politics.
Trump is the candidate whose policies, to the extent that they can be understood as policies, per se, are a recipe for a global trade war. Trump, who has also indicated a wavering commitment to honoring US debts in full, has played the role of cannon careening across the deck of US politics. Very few long-term investors are likely to view his rise positively and many would welcome his fall.
It may not be that Trump’s slide is driving financial markets now, but were he to go into November with a reasonable chance of winning the election, the resulting volatility would be frightening.
Fed between itself and a hard place
The final risk to come down dramatically in the past week is that of the Federal Reserve hiking interest rates, either sharply or any time soon. The central bank left rates on hold at its meeting last week and signalled, in word and forecast, that recent expectations of a near-term second rate hike in its campaign, which began in December, were misplaced. Not only did the Fed indicate that what it saw as short-term economic headwinds may be sustained, it raised the possibilities of new ones from abroad.
“I can’t specify a timetable” about when rates will go up again, Fed Chair Janet Yellen said after last week’s decision. “We are quite uncertain about where rates are heading in the longer term.”
Financial markets are pretty sure in the short term they will stay where they are, assigning an only 11% of a July hike and only 53% of one by the end of the year. Many investors are increasingly convinced that the Fed may even be forced to ease monetary conditions before it is able to raise rates once again.
To be sure, a vote in Britain to stay in the EU would remove one threat to the Fed’s outlook. But a host of indicators, from capacity utilization to corporate inventories and profits, are all flashing the types of signals that often precede a downturn.
This dramatic development cuts both ways, as it both ensures continued easy financing terms but also serves as striking notice that the utility of the tools the Fed has in hand is doubtful.
What was striking last week was that a dovish Fed did not evince the usual rally response from financial markets. With interest rates now at only 0.25-50bp, the Fed has little room to cut should matters deteriorate. That’s especially true due to political and economic concerns over the impact of negative interest rates
So if 2016 is the year it didn’t happen, we may get first a powerful rally and then an extended turn downward in financial markets. The global economic malaise that contributed to political upheavals in Britain and the United States is still with us, and with it, popular discontent.
Dodging bullets and being safe are two different things, investors may learn.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
