Investors need to ensure their portfolios are prepared for the impact of political risk, Aberdeen Standard Investments’ Andrew Milligan warns, as these threats are likely to dominate market sentiment for some time to come.
Numerous political risks are being played out on the global stage at the moment, including the UK going through its tortuous process of leaving the EU, the US-China trade war, North Korea’s nuclear programme, continued conflict in the Middle East and Italy’s spat with the EU over its budget, to name a few.
Milligan, head of global strategy at Aberdeen Standard Investments, noted how issues such as these have overshadowed markets more recently: “During the course of late 2018 a considerable amount of political risk was being priced into investments.”
This spectrum of ongoing tensions means Milligan believes that geopolitical issues cannot be overlooked when making investment decisions. Milligan is a member of Aberdeen Standard Investments’ global investment group, which has the responsibility for forming the firm’s house view.
In a study carried out by SSGA, geopolitical events were defined as “a transnational risk to economic activity or cross-border trade or capital flows emanating from political actors. Geopolitical events matter for foreign exchange and equity markets, but their impact differs across countries.”
It is this “differing impact” that Milligan believes is key for understanding the various ways political risks can affect a portfolio, highlighting that there are three main ways this can take place.
The first impact is local, whereby political tension in one country affects its markets in isolation rather than impacting on its neighbours.
Performance of Spain vs Europe during Catalonian crisis in euros
Source: FE Analytics
Milligan cites the Catalonian crisis. In 2017/8, a constitutional crisis emerged in Spain when the government rejected a referendum in favour of Catalonian independence, causing major civil unrest and a market reaction.
“On some occasions you can see that there is a political risk and it’s affecting the cross-border capital flows, e.g. the Catalonian problems in Spain,” Milligan said. “You very clearly saw that investors were bypassing Spain in their asset allocations but still continuing to buy Europe. So, it was a local issue.”
Another way political risk can affect portfolios is by impacting the wider region in which the event takes place. An example of this regional disruption is the UK’s decision to depart the European Union.
In the case of Brexit, Europe has not been able to escape the impact of the UK’s decision, according to Milligan. When asked if he saw Brexit as a largely domestic issue or whether he could see it having an impact on other European countries, he answered that it had had a clear impact on the wider region.
Milligan sees the Brexit referendum as having a ripple affect in neighbouring markets, as the UK and the EU are connected in what he described “as a negative vicious circle.”
“The fact that the European economy is also slowing, and only growing by about half a percent per year at present ties in as well. The UK is an important export destination for many European countries,” he said.
“So I do think that we have a negative vicious circle here. Slowdown in Europe transmitted to the UK, Brexit issues are discouraging consumer and business confidence investment in the UK and rippling back into Europe. There’s very little that the fiscal or monetary policy makers in Europe or the UK can do to do other than stabilise growth.”
Underperformance of UK and Europe since Brexit referendum
Source: FE Analytics
Milligan added that the third type of political risk is the global issues, where investors pull away from markets outside of those connected with the immediate actors. A current example is the ongoing US-China trade war.
“When we move onto issues like the US and China on the trade side, these move beyond individual cross border flows and move into the realm of the equity risk premium, or risk-on, risk-off investor aversion,” he added.
The National Bureau of Economic Research found that the trade war has cost the US economy $7.8bn (0.04 per cent of GDP), after three rounds of the US imposing tariffs on Chinese goods and retaliatory moves by the Chinese authorities.
But the impact on markets was much more significant, with trade tensions being cited as one of the main reasons why equity markets around the world lost ground in 2018.
While some political risks seem to be easing at the moment – the US and China are undergoing talks about tariffs – the Aberdeen Standard Investments strategist believes investors need to prepare for these rearing their head over the years to come.
“We are in a period of strategic rivalry between the US and China which is going to continue for the foreseeable future,” he said.
“It may wax and wane, ebb and flow and this may be a period where those tensions fall back but we still think at the end of the day, irrespective of whoever is in the White House as president the US is going to be very, very cautious indeed about a whole series of military technology, security and strategic issues in the widest range between the two countries.”
Milligan sees the geo-political risk factor as an ongoing one, recommending investors to create portfolio security through a two-pronged approach of diversification and holdings in areas of perceived safety such as government bonds and gold.
“The portfolio response of course is try to have sufficient diversification, so that if you do get any hits through, for example Brazil or Venezuela, it’s not too great for the portfolio,” he concluded.
“Secondly try to include some safe haven assets in the portfolio that will benefit on those days when life is really not very pleasant.”