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Political winds ruffle financial markets

The rapid rise in inflation will have political consequences and market impact. It has already led to a reset of several aspects of US policy, including climate change and its position in the Middle East.

| 8 min read

The ‘cost-of-living’ crisis currently engulfing much of the world will produce fallout for governments and markets. The task of incumbents in power becomes that much more difficult, whilst opposition forces have real grievances amongst many of the population which they can foment.

President Biden was spooked by the climb in petrol prices to a peak of $5 a gallon – he watches them daily as he wills them to subside. In Sri Lanka, the President and Prime Minister have been cast aside by an angry crowd of protesters seizing their homes. In Italy, the governing coalition is being prized apart by disagreements over how much compensation to offer people to compensate for high energy prices, as well as defence spending. In Haiti, organised crime has been on the rampage for a long time. One year after the murder of the President there is still no settled elected replacement. Many emerging-market countries are struggling with large import bills and juggling their debts against the background of a strong dollar.

Biden forced to backtrack on energy policy

The big increase in energy prices and the substantial rise in food prices is forcing change. It has led to a reset of several aspects of US policy. President Biden came to office to cut back on US oil and gas activities. He wished to accelerate on the road to net zero. He has now been forced to welcome more oil and gas investment and output as he fights the battles of the forecourts to keep prices down. He has also had to change his Middle Eastern foreign policy.

Joe Biden arrived at the White House determined to overturn President Trump’s policy. Where Trump spoke out against Iranian actions and policies, regarding the nuclear deal as a sham, President Biden decided to revive negotiations and seek a new deal with Tehran. He felt Mr Trump had been needlessly bellicose towards Iran.

Where President Trump was a strong ally of Saudi Arabia and the Gulf States and made good progress with getting them to co-operate with Israel. President Biden was more critical of Saudi in the interests of seeking a breakthrough with Iran. Trying to be friends with the enemies of the Sunni Gulf states and Saudi Arabia led to a cooling in relations with the US’s traditional allies in the region. When President Biden needed a favour from Saudi to turn up the oil taps to ease the world squeeze in oil and gas supply, he did not get the warm response previous Presidents might have enjoyed.

Over the weekend, President Biden embarked on a journey to restore old friendships with Israel, the Gulf States and Saudi Arabia. His Iran strategy has not yet produced a breakthrough. Rebuilding with the Gulf is a small positive for Wall Street as it helps not to have Saudi and the US at loggerheads over oil and wider matters.

Sri Lanka is suffering from an all-too-common foreign-exchange crisis.

The situation in Sri Lanka is alarming. The President has fled the country, facing, as he did, violent mobs out to remove him from office and to evict him from the luxury of his Presidential surroundings. He is under pressure to resign entirely. Sri Lanka is suffering from an all-too-common foreign-exchange crisis. The country has borrowed too much and has failed to generate enough export income to cover its large import bills.

When a country runs out of sufficient foreign currency to pay for necessary imports it needs to seek foreign currency loans from the International Monetary Fund (IMF) and World Bank which will impose strict policy requirements on the country to justify the advances.

Sri Lanka’s troubles began before the surge in oil prices. The government introduced a ban on fertiliser and pesticide use to speed the introduction of organic farming. The ban greatly reduced the output of rice, forcing the country to import a food it had always been able to grow for itself. It hit the production of tea, a prime source of foreign exchange for the Sri Lanka economy. Tourism also fell due to pandemic-related travel bans and worries about security in the country. This combination of foreign-exchange losses left the country in a weak position when energy prices rocketed. As a big importer of energy Sri Lanka was left without sufficient foreign cash to meet its basic everyday needs.

On Friday, the government imposed a curfew on people to try to stop the protests and violence. There are negotiations with the IMF, but Sri Lanka will need a legitimate government with some authority to sign a deal and impose the conditions on the Sri Lankan people who feel badly let down by those who ruled them.

A complex web of issues

In Italy, Prime Minister Draghi has kept a potentially unruly coalition together, united as they have been by not wanting a general election and by their understanding that Italy needs to be close to the EU to benefit from the investment programmes the bloc is financing. Last week, the Five Star party which had once been such a successful populist insurgent found the financial disciplines of the current crisis too much to bear. Their support has fallen a lot by being in government, and they favour a more-generous package of measures to ease the squeeze on people brought on by high energy and food prices. Facing a possible confidence vote -and one that he could lose – Prime Minister Draghi tendered his resignation but the President, Sergio Mattarella, refused to accept it.

The right-of-centre Fratelli party, which has stayed well clear of government, tops the current polls with 23% and is keen on an election. With Forza and Lega, the other two main centre-right, more-Eurosceptic parties they now command 46-48% of the vote. The Democratic party is on around 22% and Five Star has slipped from 16% earlier in the year to 10% now. Five Star is the largest single party in the current Parliament, winning 32% of the vote in the 2018 general election.

The crisis is particularly hard on emerging economies.

The bond markets will be watching developments closely. Maybe Mr Draghi can work his magic again and reassure Five Star sufficiently. Five Star do not look as if it would do well out of an early election, so it may be brinkmanship. Should the coalition fold, Italy could face an autumn election, with the prospect of parties more hostile to the EU and euro taking over. Wednesday could be decision day in the Italian Parliament over the fate of its government.

Much of domestic politics in countries other than the US, the EU and China does not trouble wider world markets and often reflects responses to major events elsewhere. The food and energy price surges are troubling many governments and should lead us to expect more changes of administration and to expect additional local political risks in some national stock markets.

The crisis is particularly hard on emerging economies that need to import energy and food. There is likely to be others alongside Sri Lanka that will need IMF support to pay the swollen bills. The EU will need to keep an eye on how much support it can offer to delay an early election in Italy. The European Central Bank will need to accelerate its work on intervention funds to keep yields on Italian bonds closer to the average of the zone. The more instability there is, the more expensive ‘the fix’ becomes. European investment has just got a bit riskier.

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Political winds ruffle financial markets

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