Politics in the era of high inflation (and why it matters to investors)

Inflation in the world’s major economies has accelerated to rates unseen outside of the 1970s oil price shocks. Consumer price index (CPI) inflation in the G7 group of ‘rich nations’ hit 5.9% in February.

The combination of pandemic-induced supply chain disruptions, the rebound in demand as economies re-open, tight labour markets, and the commodity supply shock from the Russian invasion of Ukraine, will mean inflation remains elevated, even if headline rates are close to a local peak. (see Figure 1)

Meanwhile, although wage growth has increased, aggregate wages have failed to keep pace with higher prices.

The upshot is the sharpest drop in G7 household real disposable incomes in at least half a century – surpassing even the 1970s. This squeeze on real incomes will have ongoing political ramifications that matter for investors.

French, UK elections – first major electoral skirmishes in high-inflation era

While Emmanuel Macron won re-election in the recent French presidential elections, the strong showing by his rival, Marine Le Pen, points to the political salience of inflation.

Le pouvoir d’achat was a major concern for French voters (see Figure 2). Le Pen was able to pivot her campaign away from immigration and European membership, towards the cost of living, in a way that helped her detoxify her image.

Meanwhile, Macron’s second-term agenda has been pared back – pension reform has proved particularly controversial against a backdrop of rising prices.

Figure 2: Cost of living most important in French presidential election

In the UK, the poor showing by the ruling Conservative party in May’s local elections was at least partly due to rising cost-of-living issues.

These issues are all the more challenging given that seemingly attractive fiscal responses being considered by the government, such as a value added tax (VAT) cut or fuel-bill rebates, could add to inflationary pressures and make the problem even worse.

US mid-terms next key flash point where inflation and politics clash

Over in the US, November’s mid-term elections are likely to see the Democrats lose control of the House of Representatives and the Senate (see Figure 3).

While a President’s party often performs badly in mid-term elections, the Democrats’ poor polling is in part due to the Republicans’ success in using inflation against the administration of President Joe Biden. Indeed, Republican voters appear to be more concerned about inflation than Democrats.

High inflation has already helped stymy the administration’s ‘Build Back Better’ agenda, as Democratic senator Joe Manchin resisted legislation which would be stimulative amid rising prices.

Losing control of both Congressional chambers would kill any chance of reviving Biden’s agenda, and would increase risks around government shutdowns due to political bickering over funding.

Impact on emerging market politics could be even worse

In emerging markets (EMs), food and energy together form a much larger share of household spending. For example, it’s more than 50% for many people in India. Income inequality is generally greater in EMs as well, while institutions are often less mature and more fragile. Moreover, government balance sheets are weaker, while social safety nets are less adequate.

A potentially worrying historical parallel with the current cost-of-living crisis is the Arab Spring protests of 2010-12, triggered in part by the post-global financial crisis (GFC) surge in inflation, particularly in the price of food (see Figure 4).

Those protests were followed by political, economic and financial market turmoil which, in some cases, persist today.

Social unrest has already flared up in a range of EMs including India, Chile, Peru, Colombia, Ecuador, Argentina, Kazakhstan, Morocco, Sri Lanka, Pakistan and South Africa.

Many of these countries have weak government balance sheets and a range of idiosyncratic political issues. But further protests around cost-of-living issues will make it difficult for governments to push through austerity measures, keeping country risk premia high.

Implications for investors

While much will depend on how persistent higher inflation proves to be, we think the important implications for investors are:

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.