Emphasis shifts to political events
While 2015 was a year in which investors made moves based on subtle changes in the U.S. Federal Reserve’s tone and minor developments in China’s economy, next year is expected to be about big political events.
A wave of terrorist attacks this year will likely lead to growing Western military action in the Middle East, which, combined with a number of key national elections, means volatility is expected to reign, according to economists at Citigroup, as markets become increasingly sensitive to political risk.
Markets are already jumpy. European and North American stocks dropped early Tuesday after reports that Turkey had shot down a Russian fighter jet flying over Syria. Stocks managed to shake off those fears and erase those losses by day’s end.
“Until now, financial markets have taken a relatively sanguine view of political events, treating them as regionalized and idiosyncratic,” wrote Citi economists in a note to clients. “The increasingly global nature of recent terrorist activity, along with the greater inter-connectivity of such events, will make political developments and the policy response increasingly important as a driver of risk.”
That will be a shift for investors who spent much of this year paying attention to economic matters. The rapidly improving U.S. economy has led to speculation as to when the Fed would decide to raise interest rates, which many now predict will happen in December.
Investors also saw a stock market correction in the third quarter after China announced a surprise currency devaluation amid slowerthan-expected economic growth.
“Over the past few months, markets have become transfixed by two economic drivers; Fed policy and China’s economic outlook, but an increasingly volatile and interconnected geo-political landscape could threaten the relative stability we have seen during the past two years,” said Citi.
Elections will be another theme that will likely dominate markets next year. Some of the world’s most important economies, including the United States, will hold national elections next year.
As well, the United Kingdom is set to hold its referendum on whether to leave the European Union (which must be held by the end of 2017). While current polls show a modest lead by pro-EU supporters, a so-called Brexit would be a “major negative” for the British economy and likely trigger greater volatility in European markets, Citi says.
“Politically driven events are unfolding right across the globe, but Europe looks particularly vulnerable to market moving political risks with Germany’s de-facto leadership of the EU and Britain’s membership of it increasingly under scrutiny,” Citi said.
Of course, one of the biggest political uncertainties in the market now is how Western countries will react to the Paris attacks earlier this month. While France’s president declared his country was at war with the ISIL terrorist organization following the attacks, the scope of any military reaction is unclear yet.
“A sustained increase in conflict carries a meaningful financial cost and is also likely to increase fiscal pressures, which could hurt risk appetite,” Citi said.
“It can also damage confidence. However increased conflict can also have a positive influence through increased government spending.”