Does political climate effect your investment strategy?

6th November 2011

This FT piece highlights the problem: "The direction of markets from European bonds to Asian currencies depends increasingly on politics, often in small countries and on technical issues. This is political risk writ global."

It gives the example of the election of an anti-Euro party in Finland. Investors must now assess the impact of this change in government on the stability of the Euro. It says: "To grasp fully why leaders, governments and parliaments behave the way they do – and be able to price those risks accurately – is probably beyond most investors. "It is almost surreal," says Darren Williams, European economist at Alliance Bernstein, the US fund manager. "How can I, in 30 minutes, become an expert on Finnish constitutional law?"

This Morningstar piece highlights how the picture built up through political analysis can be very different to the one built up through an examination of market activity: "Turning back to the eurozone crisis debate led by influential political thought leaders and economists, we heard total opposition to bank recapitalisations and the view that at least Greece and Cyprus should leave the euro. These are not outrageous arguments, but they are at odds with the perhaps unrealistic expectations of the investment community that are increasingly necessary to avoid a full-scale meltdown in European debt markets. Indeed, perhaps the expectation of the speed of change by the markets is completely unrealistic–they are looking for economic changes that would normally take years to implement."

However, not everyone believes that fund managers should just be sitting back and relying on the re-emergence of an emphasis on fundamental corporate qualities. There are those who believe that fund managers should have shown greater insight. commenting on the FT site: "The question here is, WHY were investors wrong-footed by political risk? OK, things may change day-to-day and that is not controllable, but the overall crisis could be seen coming years ago and good fund managers should be properly hedged."

Some fund managers are increasingly building political analysis into their investment decisions. Schroders is one such group. It admits it is not a straightforward process, but it has now built a framework for political risk analysis. Robert Farago, head of asset allocation at Schroders Private Bank says: "On occasion it will be clear that markets have not factored in political risks. An extreme example of this is the lack of market reaction in the run up to World War I. But generally political issues are multidimensional, ranging from the domestic to global, and from current crises to slow burn problems with the potential to erupt. Our framework aims to capture these issues from different angles. An analysis of various potential scenarios leads to more robust portfolio construction."

The group's current analysis has identified five priority areas of political risk for markets: the impotence of monetary policy, the future of the Euro, the 2012 US Presidential election, Middle Eastern regime change and financial repression. He adds: "The major risks lie in the countries with the largest economies, the largest populations and the strategically important commodity producers. However, smaller nations can become critical players on occasion. This is highlighted not just by the central role of Greece in the euro crisis, but also by the role played by the Finnish in electing a party opposed to any bailout, complicating the path to a resolution."

This is not just a problem for investors. It is a problem for business managers, who need to decide how to expand their businesses. A number of the management consultants have been getting in on the act.

McKinsey explains why this is so important: "If you are an investor, if you are a business executive in the most volatile and fast-moving world that we have had in the post-War period, you desperately need to know what is determining the likelihood of an exposure that you have to a country, to a sector, to a joint venture partner, to an individual investment. What's the likelihood that that will stay in place and intact given a shock hitting it, given a change that you weren't expecting?"

The Eurozone crisis may be days or years away from a resolution. It may be that the market will start to re-focus on company fundamentals early next year, or it may be years away. However, an appraisal of political risk now looks a prudent part of any investment strategy.


More from Mindful Money:

Investment Tools: Systems to steer through crisis

Market crash: The secret to investment timing

Reading List: The failure to forecast the Great Recession

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