There has been tremendous talk concerning populism and politics, but for investors, the focus still must be on these movements’ economic and market impact. So discount the news headline and rhetoric and focus on the potential market impact, but a good definition of populism is necessary for building a framework to determine risks.
Defining Populism from an Economist’s Perspective
So what is populism from the perspective of an economist? Populism, according to Sebastian Edwards and Rudi Dornbusch, two leading economists who have written on the topic more than two decades ago, is “an approach to economics that emphasizes growth and income distribution and de-emphasizes the risks of inflation, external constraints, and the reaction of economic agents to aggressive non-market policies.” The euphoria of populist change must be tempered by the reality that change has limits. The risk is whether reality will temper behavior or whether extremism leads to a crisis.
Populism’s Impact on Economics and Institutions
The reality of not following budget constraints and not using existing institutions is what defines populism in terms of economics. This applies to both left-wing and right-wing populist upheavalsExistingnt institutions and budget constraints should temper government extremes and thus populism. However, a populist government often begins as one that upends existing institutions and does not feel constrained by budgets, thus creating the potential for economic dislocations. The question is how far this upheaval will go and how much stress will be placed on the economy.
Market Risks for Investors
From an investor’s perspective, it is crucial not to follow the rhetoric but to how budget constraints will be placed under stress and potentially broken. This is the risk that has to be assessed. If the government tempers its behavior to stay within constraints, there is the potential for markets to remain relatively stable. But on the other hand, pressure to break institutions and budget constraints creates the potential for significant market dislocations. This is why we have focused on the two-tailed risks of extremes at the begging of the year.
Tail-Risk Exposure Management
Some political extremism has dissipated since January, but given its potential, we would argue that both left and right tail-risk exposure management makes sense. There is value in divergent hedge fund strategies that will make money if there is movement to market extremes. These are priced low, given the current low market volatility.