Not since the 1930s has the world been faced with such a wave of populism. The Italian budgetary crisis over the past few weeks is neither an accident, nor an exception. Investors would be making a serious mistake in underestimating this issue. With just 8 months before the European elections, the so-called populist movements are in vogue across the continent. Several parties are within striking distance of securing power, including the Rassemblement National and La France Insoumise in France, along with the Northern League and the 5-Star Movement in Italy, AfD and Die Linke in Germany, UKIP in the UK, Podemos in Spain, PiS in Poland, Fidesz in Hungary, Syriza in Greece, FPO in Austria, PVV in the Netherlands and Vlaams Belang in Belgium. Populism is also progressing in the US and in Latin America (of which the recent victory of Jair Bolsonaro in the Brazilian presidential elections last weekend is the latest proof).
Research by Bloomberg demonstrates 41% of the GDP in G20 countries is currently in the hands of populist governments compared to only 4% in 2007. According to the watchdog Freedom House, political rights and civil liberties deteriorated sharply in 2017, returning to 2007 levels, or those before the the collapse of the Soviet bloc if we include the further downturn observed in 2018.
Populism is popular. It manifests itself in the form of doubt over the independence of the central banks, criticism of supranational institutions and the rise of protectionism. The Trump administration is a perfect example, with the President’s unprecedented criticism of the Fed and additional taxes on Chinese imports. However, although Donald Trump perfectly echoes the populist threat looming over our democracies, he must not be considered as the root of these developments, but only as a symptom. The end of his tenure, whether at the end of this mandate, future mandates or more immediately, will not resolve the root cause which go far deeper as history will no doubt reveal.
According to Oxfam, global inequalities have increased significantly over the past decade. 82% of wealth created last year benefitted the richest 1% of the global population. Although 2017 saw the sharpest-ever rise in the number of billionaires, revenues among the middle and working classes increased only slightly and government states tended to become poorer. While poverty has decreased overall during the past decade, inequalities have significantly increased. The central banks’ exceptional asset purchase programmes succeeded in bailing-out the financial system, but they have failed to curb the increase in inequalities, which have become the breeding ground for populist parties. With financial markets reflecting some initial signs of volatility recently, how should fixed-income investors view this political context?
While economists debate the end of the US cycle and a probable recession, it would be wise to consider the impact of political risk, which is at least as important as economic risk, on the markets and on the broader economy. Fixed-income investors must consider 2 key questions in order to determine the risk of an investment. Can the issuer (sovereign in this case) reimburse the debt? Can it afford it? And, does it intend to?
The first question is obviously a key consideration in bond analysis. Mathematically, redemption capacity is determined by the primary budget, nominal growth and the cost of debt. We have observed that the current wave of populism is triggering budgetary expansion. Deficits in the US, Italy and China are being weighed down heavily by massive tax spending. The trend is unprecedented in terms of context rather than the extent of the deficits. The US has otherwise never launched budgetary stimulus measures with unemployment at such a low level (below 4%) in the past 50 years. Similarly, the Italian government calling a halt to austerity, with debt at almost 130%, has never been seen since the European Union was created. Overall government debt is therefore not due to diminish. Countries with control over their currency can always reimburse debt with a sharply depreciated currency. This solution is now impossible for eurozone members such as Italy.
The second question is more complicated. A government’s willingness to reimburse its debt depends greatly on the quality of its governance and its capacity to honour its commitments. The rise in populism could undermine this willingness. Historically, the number of defaults surged in Europe during the 1930s and 40s, primarily due to political changes. This was the case in Austria and Germany with the rise to power of fascist governments. This was also the case in Russia in 1918 when the Bolshevik government simply refused to reimburse debt issued by the Tsarist regime. More recently, financial imbalances and poor governance have led to a series of defaults in Africa and Latin America.
We believe that the Italian issue is therefore a question of goodwill. Does the government, along with the Italians, wish to remain in the European Union? According to an opinion poll conducted by Eurobarometer / ASR, only 30% are in favour of an Italexit, compared to less than 10% in Germany. While this figure appears insignificant, it is worth noting that according to some opinion polls conducted back in 2015, only 35% of British people wished to leave the EU. Italy’s loyalty could be undermined by a further financial crisis or a recession. Political comments on this front will have to be closely watched, as we believe that Italy’s solvency would clearly not resist leaving the European Union.
As a bond investor, it is now all the more indispensable to take governance, social and environmental criteria into account within our analysis. As well as assessing debt sustainability, we also consider the level of corruption of a country, the degree of freedom and the respect of civil liberties, along with central bank independence and the respect of institutions. To comply with the UN’s objectives, an analysis of a country’s social protection and wealth distribution is also a determining factor. Environmental criteria will increasingly weigh on sovereign debt while natural resources and pollution management are also major issues for governments. All developed and emerging economies are facing these same challenges.
Increasing inequalities, the surge in populism leading to deteriorating governance and systemic risks associated with climate change will all unfortunately lead to payment defaults over the coming years. Considering ESG criteria into our fixed-income management is no longer an option. It has become a necessity.
 Tom Olrik chief economist at Bloomberg Economics