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Is 2017 the Backlash Against the Backlash?

The recent UK election is the latest signal that last year’s “populist” political turns now face sturdy opposition, with implications for economic and market forces.

I clearly need to listen more to my wife, who thought that Brexit would happen, that Trump would win and that the UK media was materially underestimating Labour’s support among British voters. What she appreciated, and I (and many others) missed, was a growing sense of frustration with the status quo, especially among the young.

Indeed, it wasn’t that the polls were wrong about the UK election; results were close, if you took people’s voting intentions at face value. But most polling models assumed the same type of apathy among younger voters that doomed the UK Brexit referendum last year. Instead, what we got was “Youth in Revolt.”

We think that the odds of looser fiscal policy have gone up—especially in the eurozone and UK—while the odds of protectionism have gone down.

For global markets, the result is yet another chink in one of 2016’s most popular ideas, that of the “populist backlash” that characterized elections last year. Indeed, in a discussion about this theme earlier this year, a colleague of mine openly wondered if we were asking the wrong question. “Maybe this is actually the high-water mark,” he said. “Maybe 2017 is the backlash against the backlash.”

Hard vs. Soft

While outlandish at the time, that idea is gaining credence. The Netherlands rejected a right-wing party in favor of moderates. France elected a centrist over fierce challenges from both extremes. Angela Merkel looks increasingly likely to win another term as Germany’s Chancellor. The U.S. administration’s approval rating has dipped below 40%.

The latest UK election may be yet another example of the backlash against the backlash. Conservatives unexpectedly lost their majority in Parliament, while Labour made gains, in part, by arguing for a “soft Brexit” deal that preserves core elements of the existing relationship with the European Union.

For the country itself, political uncertainty has risen. Yet, at a macro level, our economists view this as a medium-term positive, with 0.2-0.3 percentage point of upside risk to their 2018 GDP forecast of 1.1% growth. Meanwhile, our currency strategist, Hans Redeker, expects the pound to do better over the next four to five weeks, as the market raises its “soft Brexit” probability.

Consensus Positioning

In the U.S., I recently attended a series of meetings that highlighted a notable division: bewilderment over how little the market is now pricing for the Federal Reserve’s policy-tightening, compared to the popularity of trades in other asset classes (positioning for gains in growth equities and emerging markets and declines in the dollar) that directly benefit from this dynamic. The consensus view almost seems to be: We think that the U.S. front-end is wrong, but (for now) we’ll position as if it’s right.

This could continue. Our U.S. economists expect the Fed to raise interest rates in mid-June and again in December, followed by four more hikes in 2018; yet, Matt Hornbach and our global rates team are skeptical that the front-end needs to reprice much in the near term, given their work on prior rising-rate cycles that suggests market rates tend to undershoot what actually materializes.

What about the bigger picture? Altogether, we think that the odds of looser fiscal policy have gone up—especially in the eurozone and UK—while the odds of protectionism have gone down. Both are supportive, for now, of our economists’ view of a synchronized, trade-led global recovery.

Adapted from a recent edition of Morgan Stanley Research’s “Sunday Start” (Jun 11, 2017) series. Ask your Morgan Stanley representative or Financial Advisor for the latest macro and strategy coverage and reports. Plus, more Ideas.