Political Risk Rising.
An alternative interpretation of what is happening post election to what Dalio said about sovereign credit.
Ray Dalio and others seem to be interpreting the sell off in the Credit markets as a sign of “increasing inflation” expectations. Some attach this to a “pro-growth” narrative of the new administration, future Fed rate hikes, etc.
However, what if instead what is happening is Political Risk is now being priced into Sovereign Credit like it had not been before? Meaning: rates have been artificially low and underpricing political uncertainty and what if now that is reversing given Trump’s victory?
Consider the fact that we just had the most unpredictable political campaign in history with a result that surprised almost everyone. This followed the “Brexit” which was similarly as uncertain and surprising an outcome.
Sure there are reasonable interpretations about future events in the U.S. economy based on stated campaign promises around taxes, infrastructure spending and deregulation that could lead to growth if implemented. But when have such promises ever been implemented smoothly? Especially after such an unpredictable election how can people be so certain about complex economic implications years after hard to implement political changes?
The alternative view is that political risk is increasing, and after years of pretending like it doesn’t exist in Credit markets that is reversing.
This seems like a much more plausible explanation for the sell off in Credit markets.
This is especially true in Europe and especially in Italy where the referendum is looming.
Most seem to be reading the equity markets as telling us something about inflation and growth, and it seems instead they may simply be reflecting a misinterpretation of what is happening in Credit.
Unfortunately, this alternative explanation could be quite devastating because it could mean that the mispricing we’ve seen in Sovereign Credit markets over the last period of years is beginning to unwind because Political Risk exists.
If this happens in a violent fashion, which seems quite possible given the upcoming referendum in Italy, votes in France and other uncertain political scenarios, the markets could get quite ugly or worse.
The unfortunate fact is these sovereign credit securities are held in systemically interconnected financial institutions, and if they decline in value precipitously, that could cause systemic risk to reemerge.
I hope this does not occur, but it seems increasingly possible that it might.
