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Markets focus on the Fed and ignore bigger issues

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Markets are braced today for this evening’s announcement on interest rate policy from the Federal Reserve. Although the probability of another 25 basis point rise in the funds target has remained at 30% or lower for the last couple of weeks (and now stands at just 20%), markets nonetheless feel somewhat jumpy. That said, this ought to have less to do with the direction of monetary policy and more with developments on the last leg of the US presidential election. Donald Trump’s brand of unrestrained populism is reaching new lows, but the risk is that, just as with the UK referendum on the EU back in June, the US election will bring out an element of protest that will prove sufficient for a surprise result. The bookmakers currently see the probability of a Clinton victory at just over 60%, with Trump at just under 40%. 

The problem with the betting markets however, is that they represent only the views of those with the money to back them up – and these people are not necessarily the best informed. In particular, very few financial market participants will have an abundance of Trump supporters in their social circles and this may lead to the view that a Trump victory is less likely than it actually is. This effect was certainly prevalent at the time of the UK referendum, when many fell victim to a form of ‘groupthink’ and came to the conclusion that a vote to leave the EU simply could not happen.

On the subject of surprise results, the elections in Berlin last weekend proved a classic upset, with Angela Merkel’s CDU winning just 17.5% of the vote. The reason for the loss of so many votes appears to have been Angela Merkel’s open-door policy on refugees, which prompted a surge in the right-wing populist party Alternative fuer Deutschland – as well as an increase in support for the Left Party, which was formed from the remnants of the old East German Communist Party. Indeed, Merkel’s hollowing out of support in the centre was so dramatic that she was forced to admit regret over her own policy.

One man unconcerned by the rigours of the electoral system is Vladimir Putin. His party, United Russia, now controls an extraordinary 76% of seats in the Duma, or lower house. However, turnout was at an unprecedented 47%, suggesting there are many voters seeking an alternative form of government in Russia which, for the moment, is simply not on offer.

Clearly, there is deep dissatisfaction amongst the world’s electorates. The slap in the face to the British establishment that was the EU referendum result appears to have started something of a chain reaction. As noted, the financial markets still believe that Trump cannot be President – and yet the polls continue to narrow. Next spring we shall have the have the French presidential election, in which Marine Le Pen’s Front National is expected to come second in the first round and then, hopefully, lose in the second. Then, in the late summer or autumn, there will be federal elections in Germany. Angela Merkel has not yet declared herself as a candidate and the way things are going, she could be forgiven for not running for a fourth term as Chancellor.

It is as if decent politicians all over the democratic world are suddenly struggling to be re-elected, and the reason is not hard to see. Living standards for the majority in the developed world have for many years been rising either pitifully slowly or not at all. This does not bring out the best in electorates.

Nowhere is this situation more visible than in Italy, the economy of which is no bigger now than it was in 2000 and which has the world’s third biggest bond market. Italy is too big to fail, and yet it is also too big to be supported by the ECB in a bail-out. This is what makes Prime Minister Matteo Renzi’s referendum on constitutional change, to be held on either 30 October or 6 November, such a crunch-point.
He has declared that, should he not win the plebiscite, which is designed to make the Italian Senate much less powerful and Italy easier to govern, he will resign, inevitably triggering an election. Although Virginia Raggi, the new Mayor of Rome, is doing her best to put voters off her M5S party, there is still the risk of this anti-EU party winning power should Renzi fail. It is very difficult to see how the EU could cope with such an outcome.

So, as we await news of whether the Fed will raise rates by another 25 basis points, it is as if markets are ignoring two elephants in the room. A Trump victory runs the risk of trade and currency wars or worse, while Matteo Renzi’s failure to secure his electoral reforms indirectly threatens the EU itself. It is hard to work out which is the bigger of the two risks; perhaps this is why markets are, for the moment, so keen to ignore them and remain content ogling the Fed.




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