What makes politics tick? Understanding political risk in markets.

21 March 2017

Accounting for political risk has traditionally been viewed as more relevant when investing in emerging rather than developed markets. However, after the electoral upsets of 2016 and the rise of 'populist' parties across the advanced economies, investors are increasingly aware of the powerful effect politics can have on developed market outcomes.

In the latest edition of Global Horizons, Stephanie Kelly, Political Economist, outlines our analytical framework for assessing the factors that drive political risk and the potential consequences for investors. By identifying risk factors within two distinct categories, institutional and cyclical, it is possible to identify the key drivers of political risk events and build an investment view that takes these factors into account. The framework is especially useful for examining the key political events of 2017 and considering how likely they are to deliver further shocks to the status quo. In particular:

  • The French two-round presidential election system makes it difficult for non-centrist parties to win. However, reputational risk for centrist candidates, security-event risks and the recent tendency for polling to understate the support for populist parties mean that a pro-market outcome cannot be taken for granted.
  • Germany's federal election in September and a potential snap election in Italy carry comparatively less risk due to the proportional representation system that these countries use. Populist success would require more mainstream parties to alter their political allegiances dramatically; monitoring party rhetoric carefully for signals of such a turnaround is therefore important.

Stephanie commented

Stephanie Kelly

"In light of recent elections in both the UK and US, where pre-election polling gave an inaccurate steer about the final outcome, our analysis suggests that uncertainty about political and policy outcomes can lead GDP growth, exchange rates and equities lower, although the magnitude and time scale of this effect varies significantly across markets.

"In the presence of political risk, scenario analysis is an effective tool for considering the consequences of different political outcomes. In the case of the US election, our pre-election scenario analysis showed that individual and corporate income tax cuts were a likely consequence of Donald Trump winning the presidential election and Republicans retaining control of both the House of Representatives and the Senate. However, it also pointed to potential conflicts in other areas of policy as the president's populist agenda rubbed against traditional congressional Republican priorities.

"While the events of 2016 and wider popular opinion illustrate a strong populist undercurrent in the developed economies, each country remains anchored by domestic institutions and idiosyncratic cyclical dynamics. By analysing political risk in a systematic way, we can dive deeper into the economic and political drivers of populism, the policy responses by mainstream parties and the associated implications for globalisation and the broader economic agenda".