Political Risk Goes Global

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Political risk—the idea that political changes can affect the value of investments—used to be a concern primarily related to emerging markets. There are still plenty of political risks emanating from emerging markets, such as Russia’s military adventurism and China’s territorial disputes in the South China Sea. But in recent years developed markets haven’t been spared as political risk has reared its head around the globe.

The latest example of political risk in developed markets comes from the first round of France’s regional elections earlier this week, in which the far-right National Front party garnered the most votes. The National Front’s success is part of a broader trend in Europe where more extreme political parties have gained popularity in countries ranging from the United Kingdom and Denmark to Austria and Hungary. The continent’s refugee crisis and recent terrorist attacks could further increase support for more extreme parties.

There are other possible political changes that could dramatically affect the value of investments as well. In the UK the government has pledged to hold a national referendum on whether the country should remain in the European Union. The US presidential election next year could alter America’s economic and regulatory policies. And any agreements that result from the ongoing UN climate change conference in Paris have the potential upend the energy sector.

Political risk has already left its mark on investments around the world this year. Greece, which was nearly forced to leave the euro zone after the newly-elected Syriza party initially couldn’t agree to a bailout deal with the country’s European creditors, has one of the world’s worst-performing stock markets so far in 2015. Turkey and Egypt, which have become enmeshed in the Middle East’s geopolitical woes, are also among the world’s worst-performing markets.

Yet simply abandoning international investments to try to avoid political risk is a mistake. The stock market in France, despite multiple large-scale terrorist attacks and the surging popularity of the National Front party, has slightly outperformed the US this year. And given how political risk has flared in Europe, it’s possible that the next market-rattling political risk could be in United States. As political risk goes global, having a portfolio that’s well-diversified internationally is a good way to mitigate the impact.

Greece Isn’t the Only Political Risk

Europe Vote

Following the “no” vote in Greece’s national referendum on whether to accept the bailout terms proposed by its European creditors, the two sides continue to struggle to reach an agreement that would keep the country in the euro zone. For investors, the Greek crisis highlights the importance of “political risk,” the idea that the value of your investments can be hurt by political factors in addition to purely economic or financial ones.

In the case of Greece, the political risk for most investors should be fairly small. As we’ve noted in the past, Greece’s economy makes up less than one third of one percent of the global economy, and the size of its stock market is negligible compared to the global market. But the Greek crisis has the potential to exacerbate other political risks in Europe that could have a larger effect.

One is the possibility that—like the Syriza party in Greece—anti-establishment political parties could come to power elsewhere in Europe and cause further political and economic fragmentation of the continent. Such parties have even gained popularity in some of the largest European countries. In France, which makes up over 3% of the global stock market, the National Front party has made gains in recent years. In Spain, which makes up over 1% of the global stock market, the Podemos party is vying to win the national election that will be held later this year.

Another risk is that the United Kingdom (which has its own currency and therefore isn’t a part of the euro zone) will leave the European Union. The country’s prime minister, David Cameron, has pledged to hold a national referendum on whether the country should leave the EU. Leaving a political group such as the EU likely wouldn’t cause as much financial upheaval as a country leaving a currency union such as the euro zone, but it could harm many British companies.

The outcome of Greece’s current crisis will affect these other political risks. The disorderly financial collapse that Greece has suffered in recent weeks has probably made it less likely that other struggling countries will risk leaving the euro zone by trying to extract more favorable terms from their creditors. If Greece leaves the euro zone and its economy recovers, however, other countries may view a euro zone exit as a more enticing possibility. Furthermore, a breakup of the euro zone could make it more likely that the UK votes to leave the EU. The political risk from Europe is far from over.

The Implications of the UK Election

UK Election

The United Kingdom has its general election on May 7th, and the election outcome could be intriguing for a number of reasons. Typically British elections are dominated by the Conservative and Labour parties, with the Liberal Democrats far behind in third place and all the other parties barely winning any seats in parliament. This time the Scottish National Party (SNP) is expected to overtake the Liberal Democrats as the third-largest party in parliament, and a slew of smaller parties such as the UK Independence Party could upend the vote. Beyond the political storylines, however, the election outcome could have implications for your portfolio.

Last September, Scottish voters narrowly rejected a referendum on whether Scotland should break away from the United Kingdom and become an independent country. A “yes” vote on independence likely would have hurt many British companies by creating uncertainty about what currency Scotland would use and how a newly independent Scottish economy would be managed and regulated. But the rejection of the referendum didn’t put the independence issue to rest. Support for the SNP, which strongly backs Scottish independence, has surged over the past 7 months. Success by the SNP in the upcoming election would increase the chances of another independence referendum.

A promise that Prime Minister David Cameron made could have an even more widespread effect on investors’ portfolios. In 2013 he vowed to give British voters a referendum on whether the UK should remain part of the European Union. Such a referendum won’t necessarily occur: the Conservative party would have to win the upcoming election and be able to form a government with only coalition partners who also agree to the referendum. But if it does occur, the political and economic uncertainty created by such a referendum could adversely affect not only British companies, but also companies around the world that operate in the UK or trade with the UK.

Many of these effects from the election may not occur for a while. Cameron’s proposed referendum, for example, wouldn’t take place until 2017, and much could change in British politics before then. But the general effect of the election for investors could be to increase the impact of political risk on financial markets. So far this year, despite conflicts in the Middle East and drama surrounding the Greek government’s finances, markets have largely shrugged off political risks. The UK election has the potential to change that.

The Biggest Political Risks in 2015

Europe Vote

2014 was filled with political risk, a concept referring to political changes that can affect the value of an investment. From Russia’s military adventurism in Ukraine to renewed US military involvement in the Middle East, headlines were filled with geopolitical turmoil. But despite all the potential political conflicts, the ones that ended up metastasizing only minimally affected most investors. Even Russia comprises well below 1% of the global stock market. Political conflicts that could have more dramatically affected financial markets—such as China’s territorial disputes in the South China Sea and Scotland’s independence referendum—mostly fizzled out without causing too much financial damage. That could change in 2015 as political risk in Europe intensifies.

The surge of political risk in Europe has been caused by the rise of radical political parties that are less favorable toward European integration. Their support has been bolstered by the continent’s slow economic growth, a backlash against so-called “austerity” policies to reduce governments’ budget deficits, and disagreements between countries with struggling economies (such as Greece and Spain) and countries with stronger economies (such as Germany) over who should bear the cost of boosting economic growth.

There are a number of countries where these parties could potentially take power. Polls in Greece suggest that the radical Syriza party could win in the country’s parliamentary elections later this month. The party has pledged to fight for better terms for Greece from its international creditors, which has led to fears that a Syriza victory could lead Greece to exit the euro zone.

Radical anti-establishment parties in other countries could also achieve success in elections this year, such as the Podemos party in Spain, the Danish People’s Party in Denmark, and the UK Independence Party in the United Kingdom. Financial markets face additional uncertainty in the UK election, where Prime Minister David Cameron (from the mainstream Conservative Party) has pledged to hold a nation-wide vote on whether the UK (which is not part of the euro zone) should remain as a member of the European Union.

With so much electoral uncertainty in Europe, and even uncertainty about whether the euro zone and European Union will stay intact over the next few years, managing political risk will be a difficult. But that doesn’t mean investors should abandon international markets, or even abandon Europe. The lesson from 2014, when some countries viewed as politically risky (such as Russia) suffered cratering stock markets while others (such as China) performed well, is that being well-diversified internationally can be a good way to handle political risk.

Q3 Recap: US Dollar Rises as Political Risk Predominates

The third quarter of 2014 was full of geopolitical turmoil: Russia’s proxy war with Ukraine, renewed US military involvement in the Middle East, and Scotland’s independence referendum were among the notable events that took place. In the investment world, this mayhem translated into weak stock markets and a rising US dollar relative to most other currencies.

The rising value of the dollar contributed to a terrible performance for commodities, which had their worst quarter since the global financial crisis in 2008, and losses for both stocks and bonds outside the US. The only asset classes that eked out slightly positive returns in the quarter were US investment grade bonds and cash.

Q32014 Asset Classes

The energy sector was the worst-performing stock sector as falling commodity prices hurt energy companies. The sector’s plunge makes energy one of the worst-performing sectors year-to-date; the health care sector, which continued to post solid returns in the most recent quarter, is now the top-performing sector so far this year.

Q32014 Stock Sectors

Stocks in every developed country outside of the US took a beating. Some of the smaller European countries such as Austria and Greece fared worst, but Australia, Germany, Italy, and Spain were among the other countries that had worse than -8% returns for the quarter.

Q32014 Countries

Political risk will likely continue to play a key role in financial markets going forward: additional political instability could cause the trends from the third quarter to continue. Much will also depend on the actions of the Federal Reserve in the US and the European Central Bank in Europe, which are moving their policies in opposite directions. The Fed is winding down its “quantitative easing” program that was aimed at boosting the economy and is now talking about raising interest rates next year, while the ECB is desperately trying to foster faster economic growth. If the ECB succeeds, European stocks could reverse the shellacking they experienced this past quarter.

Could Brazil Be the Next Japan and India?

Japan India Brazil

In recent years the world has experienced two elections in large countries that ushered in new governments pledging dramatic economic reforms and led to surging stock markets. In Japan in December 2012, the election of Shinzo Abe and his Liberal Democratic Party led to economic reforms known as “Abenomics” and big stock market gains in early 2013. In India, the election in May of Narendra Modi and his Bharatiya Janata Party also led to higher stock prices. Could Brazil’s stock market similarly benefit from its upcoming election?

Brazil’s poll, which will be held on October 5th (with a possible runoff vote later in October), pits the incumbent president, Dilma Rousseff, against a slew of opposition candidates. The most popular of these opposition candidates is Marina Silva, who only became a presidential candidate when her running mate was killed in a plane crash. Polls have shown Silva tied with or slightly leading Rousseff in a potential runoff vote.

A Silva victory could have large implications for Brazilian stocks mainly because investors tend to dislike Rousseff. Brazil has suffered from weak economic growth and high inflation in recent years, and its stock market has underperformed other emerging markets. Many investors have blamed these occurrences on Rousseff’s policies. Silva has advocated more restrained fiscal policies, reducing the inflation rate, and free trade agreements, all of which tend to be popular with investors.

Of course no two countries are identical, so there’s no guarantee that the Japan/India scenario will replay itself in Brazil. One of the biggest differences is that by the end of their campaigns Abe and Modi were romping to massive victories, while the Brazilian candidates are locked in a tight battle. But if Silva is able to pull out a victory, and has enough of a mandate to initiate investor-friendly reforms, Brazil’s stock market may follow the playbook set by Japan and India.

The Biggest Political Risk

China-US Diplomacy

We recently discussed the rise in political risk that investors have had to deal with over the past few years. But where is this risk most likely to have a meaningful impact on US investors? The answer, perhaps surprisingly, is East Asia.

That answer may seem odd given the political uncertainties in other parts of the world. Syria has been racked for years by a deadly civil war, Iraq’s government is trying to fight off an insurgency, Russian-linked separatists have been stirring up trouble in Ukraine, and military leaders have claimed power in countries such as Egypt and Thailand. But when it comes to global financial markets, these countries are bit players. Even Russian stocks comprise only about one half of one percent of the value of the global stock market. While it’s true that events in small countries can have an impact—trouble in Syria or Iraq could spread throughout the Middle East and affect global oil supplies, for example—political risks related to larger countries would be more consequential.

Since 2012, a diplomatic conflict has been escalating between China and Japan over a group of uninhabited islands in the South China Sea. China also has territorial disputes with other countries in the region, including Malaysia, the Philippines, and Vietnam. So far these conflicts have remained mostly diplomatic rather than military disputes, but there are routinely provocations that threaten further escalation. Last month China stationed an oil rig in territory claimed by Vietnam, leading to riots in Vietnam targeting foreign businesses.

A military conflict between any of these countries could roil financial markets: Japan is the second-largest country in the iShares MSCI All Country World Index ETF, while China is the ninth-largest. Furthermore, the United States could intervene in such a situation (the US has a security agreement with Japan), making the strife truly global.

The good news is that the probability of a large-scale military conflict is still very low. Yet even if the disputes remain the purview of diplomats, investors could feel some effects: trade between China and Japan has fallen substantially since their territorial squabble metastasized in 2012.

The Rise of Political Risk

One important trend in global financial markets during the last few years has been a rise in political risk, a concept referring to political changes that could affect the value of an investment. The number of events associated with political risk—such as elections, mass protests, and military interventions—has increased by 54% since 2011, according to a study by analysts at Citigroup. This kind of increase has a couple key implications for investors.

The first is that it can affect the relative performance of emerging markets versus developed markets. Interestingly, while political risk has historically been most closely associated with poorer countries, in recent years it has appeared in some of the wealthier emerging markets and even developed ones.

In emerging markets there have been protests in a wide range of countries, including Brazil, Russia, South Africa, Thailand, and Turkey. In developed markets, political posturing opened up the possibility that the United States government would default on its debt in the summer of 2011, and extremist parties opposed to the European Union did well in recent elections for the European Parliament.

A continued increase in political risk would likely hurt emerging markets more than developed markets, even if the risks aren’t isolated to emerging markets themselves. Investment typically flows from emerging markets into “safer” markets (such as the United States, Switzerland, and Japan) when perceived risk increases. This shift can take place even when the risk originates in the developed countries, as was the case when emerging markets were pummeled during the 2008 financial crisis.

A second implication of increased political risk is that it may lead to more divergence in the performance of stocks in different countries. This trend is already evident in some of the countries that have recently experienced notable political events. For example, Russian stocks have lost 8% so far this year (and at one point were down close to 25%) as the country became involved in territorial battles with Ukraine. Indian stocks, by contrast, have risen more than 20% this year as political power shifted in the country’s May elections.

EM 2014 Performance