4 steps to help protect portfolios against political risk

(AMP Capital)
08 November 2017

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 position