Understanding and managing political risk in investing

When you think about political risk, you might picture civil unrest, super high interest rates on bonds issued by unstable frontier market governments, or wildly fluctuating emerging market currencies. But in fact, political risk is equally present in the world’s most developed economies, and currently it is affecting financial markets more than ever.

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results

When you speak to professional fund managers, many of them will tell you they pay no attention to ‘the macro,’ meaning what’s going on in the wider economy or what politicians are doing. Instead, they will say, they focus on doing solid research so they can pick quality companies that will make money whatever the environment.    

While this is certainly a sensible strategy, investors cannot afford to completely ignore the political background. As we saw with recent shocks such as Britain’s vote for Brexit, Donald Trump’s presidency and volatility in the run-up to the French election, politics do have an impact on markets.

Royal London Asset Management recently asked 100 of its clients what they are most worried about for the rest of the year, and political risk was their main concern. The potential failure of Donald Trump to deliver promised economic reforms was pointed to as the biggest threat by 38% of respondents, while 22% said their biggest worry was Brexit and the eurozone crisis.

So what are some of the tactics professional investors use to manage the impact of political risk?

Holding cash

In the face of uncertainty, many investors will reduce their exposure to market swings by increasing their cash positions. Alex Scott, deputy chief investment officer at Seven Investment Management, said his firm recently upped cash to as much as 12% in its more cautious funds because of political risk, and limited exposure to US and UK stocks.   

‘We see plenty of flashing amber signals for the UK economy, and risks ahead as Brexit negotiations get underway in earnest, but UK shares have continued to make progress — helped of course by their high exposure to overseas assets. Without a repeat of last year’s boost to foreign profits from the fall in sterling and with uncertainty ahead for domestic profits, we are worried that UK equity valuations don’t fully price in the risks,’ Scott said.

‘In the US, investors are understandably ratcheting back their expectations for what Trump can achieve on tax reform, infrastructure spending and deregulation. This puts a sharper focus on valuation, where current market levels leave little margin of safety. This leaves us with clear underweights in both the US and UK, seeing better value in other equity markets around the world, and relatively high cash positions in portfolios.’

Increasing and decreasing cash holdings is one strategy professional investors will use to defend portfolios in uncertain times, but remember that holding too much cash in these times of low interest rates could also dent your potential returns. Always make sure you have enough cash for a rainy day.

Rolling with the punches

For those managers running funds with broader mandates where they have the flexibility to move between asset classes, a dynamic investment approach helps in times of political turmoil.

Hartwig Kos, co-head of multi-asset at SYZ Asset Management, says being defensively positioned in the run up to the referendum on EU membership and more aggressive during the aftermath benefited his fund.

‘While every good fund has a long-term target from which it should not stray, even during small fluctuations, it must also be able to react quickly when action is needed and assess the potential impact of seismic political risks,’ he said. 

Avoiding economically sensitive stocks

Fund managers who don’t have the option to move into different asset classes can instead manage risk by shifting their sector exposure. One way to do this in the face of political and economic uncertainty is to avoid the more domestically exposed stocks.

Mark Whitehead, portfolio manager at Securities Trust of Scotland, says he suspects companies have been holding back on investing in the UK since the Brexit vote, and this could cause future weakness in the economy. Because of this, he has been avoiding companies that are most economically sensitive, such as those in the consumer sector.  

Managing currency risk

The pound has been weak since the EU referendum and in the run-up to the general election because it acts as a ‘lightning rod’ for uncertainty over the outlook for business and the economy, said Tom Stevenson, investment director at Fidelity International.

A weaker pound is bad news for the UK’s importers but good news for exporters and international companies that report in dollars, like many of those on the FTSE 100. This is partly the reason for the index’s recent record highs.  

‘The fall in the pound since the Brexit vote has been the key driver of market returns in the UK over the past year due to the boost it gave to Britain’s exporters and overseas earners, and it will be the key driver of the economy and markets over the next 12 months,’ said Stevenson.

Investors wanting to take advantage of this can choose internationally focused companies over domestic ones. Those worried about currency movements can use hedging strategies such as put options to try to mitigate the effects of sharp currency moves on portfolios.

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