27th October 2016
Fund manager Unigestion’s Florian Ielpo, head of macro research, Cross Asset Solutions, Stéphane Dutu, fundamental analyst, Equities and Jérémy Gatto, trading, equities examines the impact and implications of political risk in investment portfolios.
Political risk is everywhere these days: just look at the Brexit headlines, the US election debates and the drama around Brazilian President Rousseff. The resurgence of political risks is probably a result of a turnaround in the perception of what globalisation does to the world. Globalisation has been a rising trend since the end of World War II and it has accelerated since China joined the World Trade Organisation (WTO) in 2000. It has been an economic game changer: China experienced double-digit GDP growth at a time when Western economies had entered a period of structurally slower growth. The public is now showing signs of frustration regarding this phenomenon: what seemed a necessary evil, greasing the wheels of the world economy, is now perceived as a “rip-off”, as Donald Trump put it during his first debate with his Democrat opponent, Hillary Clinton.
Beyond the theoretical debate around free trade, the perceived loss of economic sovereignty in the developed world is fuelling the rise of anti-establishment parties. The Brexit vote was the first crystallisation of this anti-establishment sentiment, and this anti-establishment theme will play a significant role during the heavily loaded political agenda in the remainder of 2016 and into 2017. We think political risk – the rise of political parties challenging the 20th century’s economic solutions – needs to be cautiously monitored as it is likely to be a factor in the performance of many investments.
Political risk has risen relentlessly in the EU
Polls in the European Union and the US indicate that anti-establishment parties and candidates continue to gain ground with the electorate. No longer confined to the political fringe, these forces could soon have enough support to materially influence economic and social policies. Even if they do not rise to power, their resonance with large parts of the voting population has become so significant that mainstream parties can no longer afford to ignore their demands the way they used to.
No Western country has escaped the rising popularity of protest parties and campaigns in recent years. Chart 1 shows their progress in elections in western Europe. The ever-increasing number of voters opting for radical opposition parties that dispute the benefits of globalisation, capitalism, free trade, immigration and multiculturalism represents a risk for investors. Firstly, it feeds political instability. Secondly, and more importantly for financial markets, should such a tendency persist over the next 12 months, it may well bring to power politicians with market-unfriendly agendas that could eat into the profits that global companies have reaped from the free movement of goods, services, capital and people.
Chart 1: The rise of anti-establishment politics, percentage of total vote
Source: Unigestion’s calculations based on representative elections for each country (elections with a proportional distribution of votes). Such elections include supranational, national and regional parliamentary elections.
And the big one –The US
In the US, the populist candidate Trump has gained on status quo candidate Clinton over the past few months and closed part of the gap with her in polls. However, pulling ahead of the Democratic nominee still looks like a challenging task for the fiery property tycoon, especially as he did not succeed in trumping her during much of the TV debates. However, since many Trump fans are unlikely to openly admit to pollsters that they will vote for him, his real popularity is probably higher than the opinion polls suggest. The experience of the Brexit vote has taught us that many voters are fearful of being stigmatised for expressing political opinions that are frowned upon by the media. These reticent voters limit the predictive power of surveys.
The percentage of voters who are genuinely undecided is still large, so the results of the 2016 White House race remain unpredictable. Should Trump become the next US president on 8 November, we do not think this would represent as much of a political, geopolitical or economic risk as is generally thought. Many concerns about the consequences of his election are exaggerated for the following reasons: Firstly, although the Lower House is likely to remain Republican, the Senate has a good chance of flipping back to Democratic control in early November, which would limit the power of the Republican camp. Secondly, Republican control of Congress may seem favourable to Trump, but many Republican Senators and Representatives are likely to oppose some of his unconventional and unsettling campaign promises.
Thirdly, as is usual in politics, when faced with real-life responsibilities, radical candidates tend to moderate their rhetoric. Finally, even if the US president can issue executive orders, he is not the all-powerful “great commander” but rather the “capable caretaker”, who executes the laws enacted by Congress. The US constitution stipulates that Congress makes the laws, the president executes them – even if he disagrees with them – and the Supreme Court interprets them. Congress can override the vetoes of the president with a two-thirds vote in both Houses. It has the exclusive power to declare wars, not the president. Congress also has impeachment power and can remove the president from power if the latter refuses to implement laws passed by Congress.
Even if president Trump initially remains as flamboyant, provocative and unrealistic as candidate Trump, the extensive powers of Congress would limit his powers with the aim of lessening any potential domestic or international tension and reputational damage. Denied the opportunity to continue playing the role of the offensive and unaccountable maverick, Trump could, in time, become a more disciplined and constructive leader. This could eventually persuade Congress to reflect on some of his better proposals with a view to working in the interest of the common good to defuse the social tensions in the US.
Managing political risk in investment portfolios
Political risk is by definition a short-term shock with longer-term potential impacts: the Brexit referendum is the perfect illustration of that. The UK’s economic situation will be changed two years after the official activation of the exit clause from the EU. When the Brexit result became known, it unsettled many financial assets, most of which then quickly recovered, with the currency being the notable exception. The longer-term consequences are harder to predict and little pricing of those consequences are currently observable in most of the usual financial assets used as risk hedges. Political uncertainty is therefore challenging for markets not because it brings about change but because that change is often preceded by a period of uncertainty. The short-term market impact will vary in magnitude depending on the global implications of that political risk. In most cases however, the impact on markets will be limited and often short-lived – at least, that is the lesson from the past.
When listing potential hedges against political risks, investors typically think of gold, forex, equity volatility, bonds and the US dollar. Chart 2 displays the average evolution one month before to one month after each of the past six US elections over the 1992-2013 period. On average, implied volatilities display a tent-shaped pattern around US elections, rising in the month preceding elections along with the build-up in expectations and then falling quickly thereafter as the event becomes “priced in” or passes. A long position in volatilities therefore would work as a shock absorber to any risk-oriented portfolio. Safe-haven assets offered little protection on average. In the case of gold, it actually shows a reverse tent shape, posting negative returns ahead of and after elections: volatility seems the best potential hedge for such short-lived episodes.
Chart 2: Evolution of potential hedges around US elections (averages)
Source: Bloomberg, Unigestion’s calculations. The period covers the last 6 presidential elections, from 1992 to 2013.
Chart 3 shows the same computations around the Brexit vote, with an adapted list of potential hedges. Strikingly, the pattern is exactly the same: equity and currency volatilities reacted over the period of the event while potential hedges proved to be disappointingly sensitive to the event. Here again, gold did not do the job, while bond yields dropped consistently through the period. Once more, volatility offers interesting hedging characteristics.
Chart 3: Evolution of potential hedges around the Brexit vote (averages)
Source: Bloomberg, Unigestion’s calculations.
One casualty of heightened political uncertainty is often liquidity. In extreme cases (such as Brexit), the market can fall into a liquidity trap as was the case with currency options on GBP-denominated crosses which expired on the day of the UK referendum. Deleveraging ahead of such periods can also therefore be wise.
When looking at the upcoming US elections it seems only a few markets are pricing in the risk of an election surprise. Current polls show Clinton leads by a large margin. However, as we have seen with Brexit, polls can misprice such events. In addition, polls typically tighten as the event approaches. Given current market pricing, long volatility hedging strategies could therefore offer attractive risk/reward profiles at this stage.
Globalisation and inequality: the root of all evil?
Anti-establishment parties are primarily criticising the past decisions of established parties. Government spending over the past 20 years has exploded, taking debt-to-GDP ratios to record highs. But the taxpayer money invested in each economy has largely failed to increase standards of living. The now-necessary fiscal cuts that are looming at the same time as public frustration about inequality and lower living standards is rising helps explain the current political situation.
Measuring government failure
In the aftermath of the Great Recession, public money happened to be used heavily, both to support growth and to save the financial institutions that needed to be bailed out. The average debt-to-GDP ratio (Chart 4) rose from 65 to nearly 100%. There are of course differences between countries, from the 130% of Italy to the 45% of Switzerland, but the average ratio has risen as nominal GDP growth has lagged the surge in public spending. Previous recessions have been followed by such a debt surge, but this time governments have shown weaker control than usual over their expenditure.
Chart 4: Average debt to GDP ratio, 1980-2020
Source: IMF, Unigestion’s calculation. The sample covers Austria, Belgium, Canada, Finland, France, Germany, Ireland, Italy, Japan, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom and the United States.
This surge in public debt has led various countries – especially European ones – to implement spending cuts – at the cost of creating disgruntlement among their citizens. Public finance normalisation is usually not obtained at the expense of the wealthiest part of the population, and disgruntlement is now visible in many democracies. The rise of Syriza in Greece has mainly been the reflection of the public frustration triggered by the previous government’s fiscal policy.
Many populist movements see in this fiscal strain one of the reasons for the recent decline in GDP per capita: Chart 5 shows this metric barely improved in the 2008-2014 period, and has been declining more recently. This is just an average and the dispersion around it does not favour people on the lowest incomes. This has been seized upon by anti-establishment parties. The political status quo is now increasingly seen as having lost control of their respective economies and this may well take its toll in forthcoming votes.
Chart 5: Developed countries’ GDP per capita in USD, 1980-2020
Source: IMF, Unigestion’s calculation. The sample covers Austria, Belgium, Canada, Finland, France, Germany, Ireland, Italy, Japan, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom, and the United States.
How markets see the issue
CDS and currency volatility have long been used as gauges of political and country risk. How well do they reflect this phenomenon today? Charts 6 and 7 respectively show the CDS and real exchange rate volatility for the US, the UK and a number of eurozone countries. On both charts, the start of the Greek crisis, the European crisis of 2011 and the outcome of the Brexit vote are clearly visible. Brexit is more apparent in forex volatility than CDS spreads. However, both charts deliver the same message: if political risk is on the rise, it is barely registering in the European and US markets.
The pricing of political risk for both these regions is limited; that is all the more reason to be cautious. The main reason for this apparent lack of risk aversion is probably because of central bank action: quantitative easing (QE) specifically aims to reduce risk aversion in financial markets and since 2009 it has worked perfectly. The Federal Reserve (Fed) and European Central Bank (ECB) managed to reduce the risk premium over the past 8 years, but they are now giving signs that they are in the process of changing direction.
An additional QE package from both the ECB and the Fed is now unlikely, opening the door to a potentially much more violent repricing of political risk: this risk will definitely matter in the forthcoming quarters.
Chart 6: Country CDS, 2004-2016
Source: Bloomberg, Unigestion’s calculation. “Europe” is the average CDS for Austria, Belgium, Finland, France, Germany, Ireland, Italy, Portugal and Spain.
Chart 7: Real exchange rate volatilities, 2001-2016
Source: Bloomberg, Unigestion’s calculation. “Europe” is the average real exchange rate’s volatility for Austria, Belgium, Finland, France, Germany, Ireland, Italy, Portugal and Spain.
Political risk is on the rise, yet markets show little sign of pricing this in. There are fundamentals explaining its rise, and most of them will remain with us for an extended period of time: globalisation, lower standards of living and limited government leeway to change these fundamentals, fuelling popular frustrations.
The US elections and later the Italian referendum are the next two events that investors should follow cautiously, especially as next year will feature potential anti-establishment votes. We recommend using forex and equity volatility to hedge this risk as these are the assets that show the strongest connection to such episodes of heightened volatility and the drying up of liquidity. The only caveat is that these approaches ought to work provided the political risk creates only short-term shocks, and not a longer-lasting blow to markets