The politicisation of markets: Do you need to factor political-risk into investment decisions?

3rd October 2011

There is little doubt that the political deadlock in Europe is a significant contributor to market volatility. The worry is that politics moves slowly and volatility is created in the interim because markets hate uncertainty. This CNBC video talks through the influence of politics on stock markets. As such, it is difficult to see equity markets making meaningful progress until the Eurozone situation is resolved.

High debt levels have handed more power to the politicians in the short-term. Usually, politicians have the power to shape the direction of an economy, raise borrowing levels, cut or raise taxes, create incentives for business. This will affect the environment in which corporates operate. But debt levels have left politicians holding the fate of entire countries in their hands, and therefore given them greater influence over investment markets.

Emerging market investors are used to having to assess political risk when making investment decisions – but fund managers in developed markets are used to politics having a largely unobtrusive presence in their investment thinking. It is why so many can cheerfully claim to be ‘bottom-up stockpickers', knowing the fundamentals of a company will emerge in the end.

Does the recent dominance of politics in investment markets change the game over the long-term? There are those who argue that this is a fundamental change. For example, Ian Bremmer, in his book ‘The Fat Tail' suggests that the importance of politics in economics is a permanent shift and business leaders need to forget five-year plans and begin to factor political risk into their calculations. See his interview here.

There are also signs that some investment managers are increasingly factoring it into their analysis. In this piece, Andrew Kirton, London-based global chief investment officer at Mercer LLC argues that political analysis has become significantly more important to investors.

The question is really one of whether markets will revert to assessing company fundamentals in the end. In the three years since the crisis and particularly recently, performance has largely been governed by the risk on (commodities, cyclical equities) trade and the risk off (government bonds, gold) trade. The reliance on the machinations of politicians has been largely responsible for that binary trade.

For markets to move away from this and start assessing company fundamentals, they need to have some certainty that the politics is under control. Many people believe that this will happen at some point. Nick Kirrage and Kevin Murphy, managers of the Schroders Recovery fund, say: "As long-term investors, we have learned that trying to second guess short-term trends, and using these to position portfolios, seldom delivers returns. Instead, we try to stand back from the market and attempt to identify long-term trends that we can use to create long-term value: placing emphasis on cash-generative businesses with robust balance sheets, strong management teams, and cheap valuations. The impact of falling markets on business and consumer confidence is not to be ignored, but equally neither is the significant improvement in corporate health."

Mindful Money blogger Kim Stephenson thinks: "Investment theory doesn't need politics to wrong foot it.  Reality does that. Eugene Fama (American economist) went on a great length about how a bubble in the US property market was impossible – what initiated the financial crash?  A bubble in the US property market.  People (psychologically) desperately want to be able to control and predict their lives. Markets (and behaviour) are inherently unpredictable; and complex, chaotic systems like markets and life are inherently uncontrollable. But theories make us think we are controlling things, so whatever I say, people will still think their theories would work if it wasn't for politicians, but while the politicians don't help, the theories will fail on their own anyway."

The influence of politics on investment markets creates difficulties for investors, but it does not mean investors should set aside fundamental analysis. However, an awareness of the influence of politics on markets is helpful when negotiating the current market volatility. History suggests that the markets will move beyond this at some point and start valuing fundamentals once again, but it may be some time yet.

More from Mindful Money:

Market crash: Headlining and tweeting our way to volatility

What is driving market volatility?

The 'Safe Haven' Illusion

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