The Return of Political Risk to Financial Markets

By Dr. Tano Pelosi, Portfolio Manager Antares Fixed Income

In a potential turning point for the UK and the global economy, the Brexit vote has reignited concerns of an unravelling European Union (EU) project. The severity in the response of financial markets following the decision reflects both the complacency of markets going into the Brexit vote but also an underpricing of the calamitous effects that would follow if another sovereign domino were to fall.

In recent years investment markets have remained relatively untroubled by political risk, whether it has been events in the Middle East, the US presidential campaign or the emergence of anti-establishment parties sweeping to power across the political landscape.

Like economic risk, the pricing of political risk in financial markets has been suppressed due to a steady stream of central bank intervention and quantitative easing (QE). Yet Brexit and the rising tide of populism are ultimately political risk events with wide-reaching ramifications that QE cannot resolve.

The vox pop movement currently underway, where public opinion is explored through multiple tightly edited short statements, is manifesting itself in various guises whether it’s anti-establishment parties, populist leaders or opposition to economic orthodoxy. Brexit, Trump’s popularity and the rise of minority parties in Australia are all incarnations of it.

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These political events coalesce around several common themes including anti-globalisation and free trade as well as a disenfranchised demographic that has seen little real income growth and widening income disparity in recent years.

While seemingly innocuous, the alternatives to globalisation and immigration are insular and deflationary policies which perversely hurt the very people advocating them. Indeed the swing towards the anti-establishment runs the risk of depriving economies of more orthodox and conventional policies underpinning economic reform and growth agendas.

For the EU, the ideals of free movement and capital mobility, central to its role as an optimal currency area, are being openly challenged. Free movement across the EU area has given rise to fractious politics around the refugee crisis and acts as a catalyst for further social upheaval and political risk across the continent.

Many of these social issues have been confused with perceptions of poor economic policy. Even in the face of compelling economic arguments against Brexit, the British public pursued independence regardless. The problem for investment markets is that this rising populism not only opposes much of the accepted economic doctrine, it also raises the risk of sub-optimal economic outcomes for economies everywhere.

Lasting political uncertainty in Europe could hurt investment and consumer sentiment and, over time, trade as markets assess potential break-up risks shifting capital from vulnerable members to other jurisdictions. Fractious politics also creates a negative feedback loop with the economy leading to further downside risks to the global economy and financial market volatility.

Australia isn’t immune with the all too recent risk of a political gridlock raising the chances that the government’s fiscal package will not remain intact and projections of a budget surplus and sovereign AAA ratings coming into question.

In the case of the EU post-Brexit, exit risks are further heightened given political contagion. The most vulnerable countries in the EU are likely to be those where austerity measures and the refugee crisis have conspired in significant social unrest. To this end Italy and Greece are in the eye of the storm, but Portugal, Spain and Ireland also bear watching.

The next general elections in Italy are not until 2018, however, minority detractors could force a referendum before then. Even the upcoming referendum on senate and constitutional reforms to be held in October 2016 could act as a trigger for political instability.

In the meantime, central banks are ensuring adequate liquidity to avoid dislocations in funding markets while further accommodation is likely from the Bank of England, European Central Bank and the Bank of Japan. The risks of the US Federal Reserve hiking interest rates has already taken a blow and the hurdle for interest rate hikes in 2016 is now much higher.

The reverberations across the political landscape are being felt and they pose significant challenges to the global economy and investors alike. Notwithstanding the ongoing role of QE and central banks, political risk has returned and Antares continues to monitor it closely as a key consideration in the Antares investment process. 

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