THE INCREASING NEED FOR GEOPOLITICAL RISK ASSESSMENT IN A NEW AGE OF POPULISM

We are in the midst of a bizarre and unprecedented geopolitical environment. Markets are failing to conform to established historical trends following a wave of populism that continues to influence economies across the world. Borne of political distrust and disillusionment rather than typical catalysts for populism, such as economic and employment-related concerns, the results of both the EU Referendum and US election have placed investors in unfamiliar and unpredictable positions. Effective risk management is crucial, now more than ever.

The uncertainty surrounding the “Leave” vote and Trump’s victory had a clear negative impact on financial markets in the immediate aftermath of both events. However, as is often the case, the market has a short memory. New market highs were reached just a few short months later. After surviving the initial shock, with immediate worries allayed, more pertinent long-term issues were swiftly forgotten.

Subsequently, lucrative returns were on offer as the markets returned to health. As tempting as it may have seemed to bet on such a recovery, it proved unjustifiable due to the levels of risk involved.

The initial risk and unpredictability surrounding the Trump administration was notably demonstrated by the President-elect’s tweets, where criticisms of Toyota and Lockheed Martin resulted in sizeable share price shocks. More recently, his influence has faded and his tweets no longer carry the same weight, while several high-profile CEOs resigned their posts on presidential committees, leading to the Strategic and Policy Forum, and Manufacturing Jobs Initiative being disbanded.

This change in sentiment may have been informed by the apparent waning of Trump’s authority – particularly his failed attempt to repeal Obamacare. Investors no longer believe his more radical policies will be enacted.

However, a toothless administration creates other difficulties. The resulting stagnation of the American political system is putting much needed reform at risk. While there has been agreement recently over lifting the debt ceiling until 2018, the administration must now negotiate the House and Senate, despite Republican majorities, to pass the reforms promised by President Trump, including a new tax policy which would likely receive cross-party support if it ever makes it to the floor.

As for Brexit, the seemingly settled markets will soon be exposed to the negotiations with the EU and the dawning reality of the decision to leave.

Volatility will surround these developments in the short-term, however, investors should not be basing decisions on rumours emanating from talks. With both sides negotiating on the understanding that “nothing is agreed until everything is agreed”, to do so would be an unnecessary gamble, though this is unlikely to stop speculators.

Investors are therefore taking on risk at a level not seen since the financial crisis. Going against all historical precedent, no risk seems unsurmountable. Yet, they have not been taking an entirely careless approach.

Looking ahead, there are several events which may prove to be catalysts for a market collapse. Chief among them is the prospect of a deterioration in the relationship between the US and China.

Thus far, China has responded to the aggressive rhetoric of the Trump administration with surprisingly diplomatic tact. Despite this, there remains a lingering tension. Behind closed doors, China will be preparing a more forceful stance should Trump escalate his criticism. The current situation with North Korea complicates matters further – though it is likely that the US and China will need to collaborate to create a viable long-term solution, which could improve relations.

A breakdown in relations between the world’s two largest economies and any resulting trade dispute would increase fears of deglobalisation. Given the dependency of the world economy on the freedom to trade and expand into new markets, any event jeopardising this would have severely negative effects on the investment viability of major firms as their expansion plans are called into question.

Russia causes further concern. A decline in international relations and any resulting trade disruption would create major problems for Russia’s economy due to their dependence on commodity exports. Though the impact would be offset slightly by the weak ruble decreasing the relative production costs, the EU will likely be impacted should Putin look to distract from the situation with an aggressive foreign policy, picking fights to deflect attention.

Within the EU, Italy is the most obvious source of political risk. Recent polls suggest a likely outcome of the upcoming election may be a populist coalition headed by Silvio Berlusconi’s Forza Italia joining the Northern League and Brothers of Italy parties. If this prediction is accurate, and the country’s simmering Euroscepticism represented by those in power, the Eurozone would be threatened, not just by the loss of Italy from the EU, but the potential of other countries following suit. In reality, the political gesturing to leave the EU may be borne more of a desire to win votes than to actually walk away from Brussels. In light of Teresa May’s current situation, many politicians would think twice before following through.

A populist victory in Italy would not necessarily need to be a negative development for investors. The economic policy of Italy’s populist parties is relatively economically progressive and may be exactly what is required to finally drag the country out of its malaise. The markets would likely react in similar fashion to Trump and Brexit, fearful and negative initially, returning to highs just months afterwards.

Any one of the eventualities above would, at the very least, cause major turbulence in their local markets. Investments must be carefully managed in order to account for such events.

Other economic indicators are providing unusual readings compared with historical data. The current ultra-low interest-rate environment is unlike anything that has come before. Equity and bond market volatility is extremely low, whilst political risk indicators, such as the Morgan Stanley Uncertainty Index, are extremely high. Generally, when comparing the VIX (US equity market volatility) or MOVE indices (bond market volatility) against the Morgan Stanley Uncertainty Index, they are strongly correlated. Yet, Central Bank policies around the world have led to volatility being artificially smoothed.

It is currently very difficult to take market protection in a traditional sense. The skew of expensive put options (protection on the market falling) and cheap call options (protection on the market rising) demonstrates a continuing cautious investor sentiment since the market correction and oil price collapse at the end of 2015. Historical trends have been subverted, with a mismatch in sentiment and volatility. Generally, low volatility would correlate with lower put option prices. In addition, bond yields are still very low – currently almost US$ 9 trillion worth of bonds have negative yields – making them an unattractive option.

How then should investors approach such events to mitigate geopolitical risk? Although total protection will never be an option, it is important not to lose sight of the often forgotten priority of investment – not losing money. Greater emphasis should be placed on the process of building returns consistently, rather than chasing high-risk wins in the short term. Our investment decisions are based on continually monitoring risk and weighing that against the value of potential returns. Should there be a disparity, risk is gradually dialled down providing the optimal balance of risk and reward.

Reducing risk exposure is undoubtedly a difficult situation – all usual options are oversaturated and unattractive. As such, alternatives must be considered. Approaching the issue on an asset class basis, there are a couple of more favourable options. US cash has begun to show favourable yields following recent rate hikes, while fixed income products currently have historically low durations. We still maintain around 20% in our core equity product, predominantly in defensively oriented companies.

We are going through a uniquely peculiar time. In addition to the difficulty of planning for such unpredictable political events, the markets are not behaving predictably in response to them either. Attempting to exploit this could prove costly. Instead, geopolitical risk assessment should be a priority.

The bull-run will end, markets will lose their central bank safety blankets and investors will be exposed to the full brunt of future political trouble should they fail to take appropriate actions to preserve capital.