The hardest landing for markets: A continued rising tide of populism

The biggest threat to the markets isn't a Trump presidency. But if you're looking for a series of events that could usher in the end of the seven-plus-year bull market, politics is the right place to look. You just need a much broader lens. It's populist policies across the globe that could sink stocks and roil bond markets.

A stress test of investment portfolios conducted this past summer by MSCI found that European equities could lose almost a fifth of their value in the next two years if the influence of antiestablishment, populist politics continues to make gains. The situation would be barely better for investors in the United States. The same analysis found that the U.S. equity market could lose almost as much — 17.7 percent, versus 19.5 percent for European stocks. The yield on the 10-year Treasury, meanwhile, would rise by 1 percent.

The rationale is straightforward: Should populist platforms in both Europe and the United States result in reduced trade and increased government borrowing without a corresponding rise in revenue, GDP will suffer while prices will rise. Specifically, GDP growth in Europe and the United States would contract by 3 percent, and inflation could rise by 3 percent by 2018, MSCI found. "Populist policies lead to stagflation, a portmanteau of low economic growth (driven by restrictions on trade) and inflation spurred by excessive public borrowing," MSCI wrote.

"If populism prevails, the markets must prepare for a hard landing," the MSCI report concluded.

If you are looking for a precursor, consider Brexit. On Oct. 18 the U.K. reported a surprise rise in inflation, from 0.6 to 1 percent, with many economists expecting it to peak at between 3 percent and 4 percent in 2018, according to a Financial Times report. "With populist policies, it might be a real possibility of returning to inflation without a return to growth. It is a scenario hard to ignore," Remy Briand, managing director and global head of research at MSCI told CNBC.

In mid-September the European Union Commission President Jean-Claude Juncker alluded to the danger of an unprecedented rise of "galloping populism."

"There are too many areas where the scope in which we cooperate together is too small and national interests are brought to the fore. European integration cannot be left or bow to the interests of individual member states," Juncker said in his State of the Union speech.

MSCI is not alone among market participants that have been in populist worry mode since the summer, coinciding with Brexit and Trump's July peak in the polls.

Byron Wien, vice chairman of Blackstone Advisory Partners, part of the Blackstone Group that manages approximately $350 billion, wrote a commentary for Barron's evoking the uncertainty that is weighing on all investors. "Europeans have no idea of what to expect after the new leadership takes over in Washington. They would expect Clinton to follow Obama's policies but are unwilling to count on that."

Wien wrote "The confusion that populism has created on both sides of the Atlantic has made asset-allocation decisions difficult for European portfolio managers. I didn't find anyone who was enthusiastic about any asset class. Most were looking for a place to hide until the outlook clarified, but the feeling was that the investment landscape would not improve soon."

The Blackstone executive noted that the surprise rise of populism comes amid difficult long-term challenges, including health care for an aging developed world, climate change, terrorism and immigration. "In an investment environment already afflicted by low returns, these longer-term problems may make asset allocation even more difficult."

Briand made clear — he spoke with CNBC in mid-October when polls already showed an almost insurmountable lead for Hillary Clinton — that both candidates for the U.S. presidency representing both ends of the political spectrum have emphasized policies characterized by protectionism and deficit spending. Democratic candidate Hillary Clinton has been pushed to the left by the Bernie Sanders–Elizabeth Warren wing of her party. Clinton, once a supporter of the Trans-Pacific Partnership, is now against it.

MSCI makes specific reference to opposition within the United States to the global economy, including opposition to imports from developing countries, U.S. firms investing overseas and populist support for an increased level of U.S. defense spending.

"We are not forecasting the outcome of the election. What we are saying is that by looking at the past, as well the current policies which have been proposed by political parties in Europe and U.S., on both sides, we draw the conclusion that there will be an effect on growth and inflation," Briand said.

Though MSCI does not make investment recommendations, it ran the analysis to offer investors a way to think about a response to extreme scenarios. Fixed-income portfolios with lower-duration sovereign debt and inflation-protected government securities could be included among the populist policies gainers.

Analysis of a diversified portfolio of stocks and bonds predicted that a rising tide of populism in the United States and Europe would have the potential to lower the total portfolio value by 11 percent. A diversified equities basket could lose 15.6 percent, while yields on a portfolio of fixed-income securities could fall by 4.6 percent.

"Global equity sectors suffer greater losses overall amid a rise in populism as economic growth declines more worldwide," MSCI concluded. "Cyclical sectors that tie to growth could underperform relative to market, while defensive sectors could outperform. Industrials benefit from a rise in populism as governments favor defense and infrastructure."

But sector performance is less clear, based on actual data from Argentina and another South American example — Brazil — where populism began to rise in 2010.

MSCI noted that:

• Materials have suffered persistent losses relative to market in both Argentina and Brazil.
• Financials, a sector that could be hit as governments intensify control, have severely underperformed the market in Argentina, while nearly returning the same as market on average in Brazil.
• Industrials and consumer staples, two sectors that lend themselves to benefit from fiscal expansion policies, have outperformed over the period examined in Brazil but underperformed in Argentina.

A look closer to the individual investor view of the world should pose the populist conundrum in a more visceral, everyday way, according to Mitch Goldberg, president of investment advisory firm ClientFirst Strategy.

"Consumers don't like rising prices, and when the populism backfires, we'll go back to less-restrictive trade policies. When Americans see that they have to pay more for everything at Target, they'll forget about populist polices in a heartbeat," Goldberg said. "What about the coal miners and the assembly-line workers? Well, what about my checking account and Visa statement?"

Reactions to currency fluctuations and other economic factors come incredibly rapidly, too. "This isn't like the days when NAFTA was passed. Feedback comes almost instantaneously, which helps with crafting trade agreements and policies," he said.

While developed economies are today in a deflationary environment, MSCI warns of the risk of soaring inflation due to political populist regimes. That will happen with an increase in government borrowing without a corresponding rise in revenue. "Populist regimes have this tendency to put more emphasis on national spending," Briand said. He stressed that there is the need for pro-growth investment policies that restart a positive cycle of inflation. As an example, he cited infrastructure: "It is a topic both politicians in the U.S. and Europe are promoting in general and links back to supporting the local workforce," he said.

Looking out 12 months, Goldberg said the reality is very few countries could afford to be populist. The MSCI analysis noted that GDP growth in the major developed markets — the United States, Japan, the U.K. and the European Union — was stagnant between 2009 and 2014 compared to previous periods and average GDP trends.

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"Everyone else needs us and each other to import and export, even the U.S. and Germany. ... I do not think populism is going to be the long-lasting bugaboo that investors expect," Goldberg said.

For those who remain more pessimistic, MSCI highlighted two actual economies that could provide a glimpse of where things may go if populism's rise continues: Argentina and Venezuela.

"Growth and inflation patterns during populist regimes in Venezuela and Argentina share similarities, mostly in line with the four phases. After growing in the early years and riding the global economic boom in the run-up to the 2008, both countries have struggled to recover from the financial crisis," MSCI reported. "Venezuela is still experiencing a severe recession, possibly exacerbated by the decline in oil prices and a rate of inflation that exceeds 100 percent per year. Argentina has entered stagflation, with near zero growth and inflation of about 25 percent annually."

— By Nasos Koukakis, special to CNBC.com. Additional reporting from Eric Rosenbaum, CNBC.com