How to protect against political risks – like Brexit and Trump
Today is ‘Super Tuesday’ in the US, while last week, all the talk was about ‘Brexit’. These newspaper buzzwords rarely figure in investor strategy meetings. But a new spectre is haunting markets: the spectre of political risk.
By Friday 19 February, the sterling-dollar exchange rate had been testing secular lows for a month. On top of policy divergence between the Bank of England and the Federal Reserve, negotiations over a new settlement between the UK and the European Union had introduced the risk of ‘Brexit’ – Britain exiting the EU – into the trade. Many thought things were overcooked, and indeed the exchange rate pulled back in late trading as news of a deal trickled out from Brussels.
But then came Sunday night. Boris Johnson, the charismatic mayor of London tipped to challenge for leadership when David Cameron leaves office, announced he would campaign to leave the EU. Sterling opened sharply lower on Monday, and as a surprising number of UK cabinet ministers joined the ‘leave’ camp, it burst through resistance levels, falling almost 4% against the dollar in four days. ‘Brexit’ was suddenly a market-moving risk.
We have witnessed something similar in the US. Even a month ago, a second-place finish in the Iowa caucuses persuaded many that Donald Trump’s bid for the Republican Party’s presidential nomination was finally choking. Trump, the Democrats’ Bernie Sanders and other ‘non-establishment’ characters would grab the headlines. Volatility might erupt in certain sectors thanks to the rough-and-tumble of the campaign – witness biotech stocks after Hillary Clinton’s comments on drug pricing last fall. But familiar-looking figures would end up contesting the general election and no single party would get enough leverage on Capitol Hill to change current economic, and therefore market, realities.
We ourselves worked on that assumption until very recently. Three Trump victories and a Boris defection later, it no longer suffices: when these things move markets, asset allocators need to take them into account, too.
At the same time, one should not lose sight of an important truth: politics makes for great blogs and cocktail-party talk, but the vast majority of it does not affect economic realities for the longer term. The market volatility it generates is often just noise. To put it another way, at this point we do not see any of these things as identifiable investment themes for the longer term, in the way that the election of Shinzo Abe in 2012 has been. But they are risks that need to be managed.
How might asset allocators frame this problem? We see three potential courses of action:
- Hedge specific risks, or make specific trades related to expected outcomes
- Reduce whole-portfolio risk exposure to take account of additional, generalised volatility
- Take contrarian positions when you believe pricing has gone too far
When political risks begin to move markets, we believe it makes sense to do at least one of these things, but possibly to do all three at once, in different markets. Right now, so many risk factors are resonating – from ‘Brexit’, Trump and Sanders, through the rise of populism in Europe and the faltering of ‘Abenomics’ in Japan, to loss of confidence in central banks. Identifying specific hedges is difficult to do. Alongside the oil price, concerns about China’s growth and flagging US corporate earnings, these things add up to make us favour the second option, managing whole-portfolio risk until we get more clarity.
When there is more clarity, we may favour option one or three, double-down on option two – or possibly revert to a medium-term strategy of adding risk assets at appealing valuations. The important thing is the thought process, which we think provides a frame of reference for asset allocators who need to acknowledge the recent elevation of political risk in markets without being tugged this way and that by the daily headlines.
Erik Knutzen is chief investment officer, Multi-Asset at Neuberger Berman