The return of the political-risk trade

Confluence of major political events comes as global growth shows signs of slowing.

  • By Georgi Kantchev,
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After a long period where investors mostly shrugged them off, political risks are once again taking a front seat in moving markets.

For investors, that promises to bring further uncertainty during one of the market’s most volatile stretches in years.

In recent years, global economic growth and central bank stimulus have drowned concerns over political risk. Now it’s back.

On Monday, markets mainly climbed as Mr. Trump prepared to meet with Kim Jong Un and Italian media reported Rome’s antiestablishment government had ruled out leaving the euro. But a bad-tempered meeting of the Group of Seven major economies reignited some investors’ worries about trade tensions.

North Korea, stresses in the eurozone and trade tensions have been among a number of political factors spurring often vertiginous moves in stocks, bonds and commodities in recent months.

This confluence of major political events, with additional turmoil in the Middle East and Venezuela, comes as global growth shows signs of slowing and major central banks start withdrawing the easy money policies that have smoothed markets for several years.

“It’s a different, more volatile environment so markets are much more prone to react to political risk,” said Mark Heppenstall, chief investment officer at Penn Mutual Asset Management.

Typical market barometers of political risk like the Swiss franc and the Dow Jones U.S. Select Aerospace & Defense Index (.DJX) have risen in the past month. Shares of small U.S. companies have also recently been outperforming their multinational peers, which are more sensitive to trade and geopolitical turmoil.

In recent months markets have crested and ebbed as international trade tensions rose. The U.S. slapped steel and aluminum on allies in Europe and North America and is locked in at times acrimonious negotiations with China over the trade deficit.

The widely used Global Economic Policy Uncertainty Index, which tracks mentions of the words “uncertain” and “uncertainty” in major newspapers’ articles about economic policy, rose in May to its highest level in a year.

Geopolitical instability is now the number one concern for companies investing in Europe, according to a recent survey by Ernst & Young LLP. In 2016, the last survey conducted, it was the fifth biggest concern.

For investors, political events are difficult to interpret and their effect on the real economy hard to read at times. As a result, investors expect volatility to remain elevated and riskier assets to be under pressure.

“There is a growing binary-ism to investors’ perceptions of risk,” said Peter Atwater, president of research consultancy Financial Insyghts. “When investors have started to price in risk, they have done it with a chainsaw, not a carving knife.”

Take Italy.

Last month, bourses around the world convulsed and the euro fell to a 10 month low after two euroskeptic parties formed a government that sparked concerns the country might exit the eurozone. Markets calmed the next day after assurances to the contrary, but European bonds have continued to whipsaw on the risk, rising again on Monday.

“The even bigger risk is that as investors see repeated binary behavior, they start to anticipate it,” Mr. Atwater said.

To be sure, political risk has moved markets at times in recent years. Britain’s Brexit vote and Donald Trump’s election sent markets around the world on a wild ride, while tensions in the eurozone and Middle East have reared up occasionally.

But for some time, investors had been relaxed about political risk. Last year, markets marched higher despite escalating rhetoric and threats of military action between the U.S. and North Korea. Turmoil in Syria, including in April U.S.-led strikes on the country’s chemical weapons facilities, didn’t dent the rally. A series of key elections and a referendum in Europe did little to unnerve investors.

“Last year investors seemed to ignore every risk out there. Now people are more sensitive,” said Eric Stein, co-director of global income at Boston-based Eaton Vance.

The growth story recently is showing some signs of wear. Global purchasing managers surveys fell from multiyear highs and economic data in the developed world has missed economists’ expectations by a wide margin, according to Citigroup’s index on economic surprises. Such data easily exceeded expectations for most of 2017.

Meanwhile, investors realize that the Federal Reserve and other developed world central banks are taking away the backstop of abundant liquidity they had pumped into markets in the aftermath of the financial crisis.

“We do not believe markets are fairly pricing the level of current and potential global geopolitical risk due to distortions such as central bank liquidity,” analysts at BNY Mellon Asset Management wrote in an April report.

This week, the Fed is expected to raise its benchmark short-term interest rate by another quarter percentage point. The European Central Bank also meets this week, with officials recently sending signals that they could soon decide to further wind down their massive bond-buying program.

“In such a world if shrinking central bank liquidity investors become more acute to risks like political headlines,” Mr. Stein at Eaton Vance said.

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