When Australia’s High Court ruled deputy prime minister Barnaby Joyce ineligible to sit in Parliament because of his dual New Zealand citizenship, the decision briefly sent tremors through equity and currency markets. It was a clear reminder that political risk matters to markets.
We face troubling political and geopolitical risk across the world: Trump, Brexit and, above all, the risk of nuclear confrontation with North Korea. Yet some investors, used to QE-fuelled rises, have simply forgotten about political risk and are maintaining highly concentrated portfolios, which exposes them to the fallout from political shocks.
To protect against heightened risk to portfolios, advisers and investors need to begin assessing political risk objectively from a multi-dimensional perspective. This involves four key steps. If they can grasp those steps, they will not only get better portfolio protection, but also gain a broader insight into the field of managing risk and uncertainty as investors.
1. Put some odds on it
The first step is to put some probability on the risk of the event happening. As we headed towards Britain’s referendum on whether to remain in, or leave, the European Union, we believed the probability was 50/50: there was a 50 per cent chance a leave vote would win; and a 50 per cent chance Britain would stay in the EU.
But the market was pricing in a much higher probability of Britain remaining - 80 per cent. Financial markets were pricing in the prevailing view in London and ignoring the rest of the country. The market, therefore, hadn’t priced in the risk of Brexit, especially in the pound. We took advantage of that gap and took a short position in the pound as a hedge.
2. Assess likely impact
The second step is to determine the impact of the political event. If the impact is likely to be extremely high, then it may make sense to move to help protect your portfolio. A North Korean nuclear attack might be unlikely, but the impact would obviously be horrific.
But sometimes the market overstates the possible impact of a political event. The market frets about a Donald Trump impeachment or US political risk. But we believe the impact of an impeachment and political paralysis is relatively low.
The impact might be high in the short term, but not in the long run. For the first time in eight years we have the Republicans in control of both the Senate and the House and they are motivated to get a fiscal package announced before the mid-term election in 2018. So, it’s a risk we’re aware of but we’re not doing anything about it.
3. Ask how much of that bad scenario is priced into the market.
The third step is to analyse how much the political risk is priced into the market. Broadly, if everyone is talking about a political risk, it’s usually priced in and it’s too late for us to do anything.
But other various measures provide guidance, including volatility and sentiment measures. Low volatility and crowded positions usually mean investors are not pricing in risk. Conversely, if investors are avoiding or have sold out of a position, volatility is high, valuations are cheap, and everyone is talking about it, then political risk is likely priced in.
Sentiment measures help gauge investor enthusiasm. If everyone is enthused about the downside, then bad news is priced in. If everyone is enthused about the upside, then risk is usually not priced in. Valuations measures such as price-to-earnings and price-to-book ratios for equities, and real effective exchange rates for currencies, are also useful.
4. Construct a portfolio that accounts for risk
The final step is to construct your portfolio to account for the risk. That may involve using put options, shorting an asset class, or using currencies to hedge.
If we look again at North Korea, our previous steps have told us that the probability of an attack is low. That’s similar to what the broader market believes. But the impact if it did happen would be devastating, so we want some protection in the form of a ‘tail hedge’. (A tail hedge helps protect against extreme market event scenarios that are unlikely to happen, but have a very high impact.)
What is an asset class that would benefit in the unlikely event of a North Korean attack? Gold. Because the probability of an attack is low, we have a small 3 per cent allocation to gold. But if North Korea attacked, the impact would be so huge that the small allocation to gold is likely to multiply upwards of 300 per cent.
Currencies are another great lever for managing political risk. Italians go to the polls to elect a new government by May 20 next year. There is a risk, albeit relatively low, that Eurosceptic parties will do well, triggering fresh talk of a breakdown of Europe. But we don’t believe that risk is priced into the euro, which warrants a short position.
Less fearful investment
The recent events surrounding Barnaby Joyce’s eligibility, as well as the history of markets shows that political risk surrounds us, and that political events can rock markets and severely damage portfolios. Yet when political risks hit markets, investors are often caught by surprise. They then panic, as they did back in 2008, and often sell at exactly the wrong time.
I well remember back in October 2008 when the House of Representatives rejected a $700 billion financial rescue package, triggering one of the biggest stock sell-offs in history. The market had been expecting the bill to pass.
By firstly being aware of political risks, then objectively assessing those risks, investors can remove that emotional element and better prepare their portfolios to weather those risks. Not only is their portfolio potentially going to benefit, but their fears around investment performance and volatility will also ease.
While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.