Politics and the economy are intertwinedled

The United States and China are embroiled in a trade war. Britain must soon leave the European Union. Italy’s populist government wants to go on a spending spree. Political uncertainty can hurt financial markets, but also create profitable buying opportunities.

At one time, students studied ‘political economy’. This field of study branched off into the separate disciplines of ‘political science’ and ‘economics’. From time to time financial markets remember that politics and economics remain intertwined. Indeed, we think that political tensions have had a hand in driving down stock markets worldwide.

The United States and China are sliding deeper into a ‘tit-for-tat’ trade war. These are the two largest economies in the world, of course. Their trade war is likely to disrupt supply chains and leave the world economy worse off.

President Trump believes that he can ‘win’ this trade war. That’s because the US imports lots of Chinese products. China imports much less from the US. As a result, President Trump has a much larger number of targets than the Chinese do.

Risks include the trade war, Brexit, Italy

For Canada, the trade war is mixed. On the one hand, China is likely to shift its imports to other countries. We expect that Canadian farmers, for instance, will take market share from American farmers (for soybeans, pork, seafood and so on). On the other hand, if China exports less, it will have less need of resources produced by Canada.

Another source of political uncertainty comes from the United Kingdom’s departure from the European Union. Will it reach an acceptable deal with the EU by March or will it face a ‘hard Brexit’? Will the UK remain the world’s fifth-largest economy or is it doomed to decline? What will happen to London’s status as Europe’s pre-eminent financial capital? We don’t know, which creates uncertainty.

Yet another source of political uncertainty arises from Italians voting for two populist parties that have formed a government. They contend that austerity imposed by the EU has crippled the country’s economy. When the former government cut its spending, Italy’s economy shrank. This made it miss financial targets, which led to more cuts and missed targets. Italy’s populist government wants to replace this vicious cycle with a virtuous cycle. They figure that running a sizable deficit will put more people back to work. With more income tax coming in, the government could eventually balance its books.

Italy plans to run a deeper deficit than allowed under the EU rules. This has caused a standoff between the Italian government and the EU. The problem is that Italy’s government debt is significantly larger than the economy. The uncertainty and the danger of a default means that Italy will have to pay much higher interest rates. This could cause Italy to use lire instead of euros. The currency union is at risk.

Here’s what you should do

There’s not much that you can do about political tensions. To the extent that they depress financial markets, however, you can profit.

Consider the UK’s departure from the EU in March. The uncertainty has reduced the value of the British pound. You can buy a pound for only C$1.69. What’s more, most British stocks have suffered to. That’s why FTSE 100 stocks now yield an average of 4.65 per cent, according to Bloomberg. (The FTSE 100 is the major index of British stocks.) Some high-quality Canadian stocks are also less costly now.

You should hold high-quality, dividend-paying stocks. In fact, you should buy more while the market is down. If you lack the nerve to do so, you can accumulate cash and invest when the next ‘bear’ (falling) market comes along. But stocks are more profitable than cash.

This is an edited version of an article that was originally published for subscribers in the November 30, 2018, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

The Investment Reporter, MPL Communications Inc.
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