Geopolitical risks have intensified over the past month or so with Brexit, the terrorist attack in Nice, the shooting of police officers in a number of cities in the United States, the tragic shootings in Munich, and the failed military coup in Turkey.
Yet, financial markets remain relatively calm all things considered.
Although political risk induces a degree of fear and loathing into investors, central bank liquidity remains the dominant force and this is what is keeping markets moving upwards.
The Bank of England remains the immediate focus as it is the central bank that is directly in the eye of the Brexit storm.
The Bank wants its actions to be seen as having a medium-term orientation as opposed to reacting to the immediate uncertainty created by the Brexit referendum.
It wants to ensure that any easing on August 4 will not have a negative effect as this would risk encouraging doubts over the effectiveness of monetary policy.
We think the UK central bank will announce (1) a 25bps rate-cut to 0.25%; (2) an extension and modification of the Funding for Lending Scheme scheme and (3) a £75bn QE programme consisting of government (£50bn) and private-sector (£25bn) asset purchases.
The QE programme will likely begin in early September when market liquidity improves following the August lull. The UK is also set to benefit from a fiscal stimulus package, which the new Chancellor of the Exchequer Philip Hammond is set to unveil in the Autumn.
Meanwhile, over in Japan the central bank looks set to ease policy again at its end-July meeting before Shinzo Abe’s government announces new fiscal measures in the coming weeks to boost the flagging economy.
But if ever proof was needed that monetary policy has its limitations it’s in the Land of the Rising Sun.
In the past week, the International Monetary Fund revised down global growth forecasts for the fifth time in the past fifteen months.
And one can’t help thinking that the markets are very complacent about developments in Turkey, even if the attempted coup was defeated.
Turkey matters along a number of lines. First and foremost, the country sits in an important geopolitical location, as it straddles both Europe and Asia with its borders, shares a lengthy frontier with Syria, Iraq, Iran, Armenia, Georgia, Bulgaria and Greece.
Across from the Black Sea are Russia and Ukraine. If Turkish politics undergo a lengthy period of instability, this is a highly negative development for the region.
At the same time, Turkey is a member of NATO, with that organisation’s second-largest military establishment. It is also the base for a sizeable US military presence which cannot be easily replicated and is important for American efforts against the Islamic State.
Another way that Turkey matters is that it is an important emerging market economy.
With a GDP of over $700bn and a population of close on 80 million, Turkey has attracted considerable foreign investment and its sovereign and corporate bonds are held by portfolio managers around the world.
Investors should enjoy the stock market run while it lasts, but problems cannot entirely be painted over with the mantra about interest rates being lower for longer and central banks providing endless liquidity.
The chances are that political risk returns in the latter part of the year in the form of the US Presidential election, Italy’s Senate reform referendum and bank problems, the Presidential election re-run in Austria and new tremors as regards the Chinese economy.
On top of that, there is the possibility of a changing of the political guard across Europe in 2017, with key elections in Germany, France and the Netherlands.
At the end of the day, central bank liquidity can go only so far, but eventually, reality, not to mention gravity, will kick in, with markets collapsing under the weight of all that “unreal” money.
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