Political Risk in Financial Markets

Clarion are acutely aware of the recent increase in political rhetoric throughout the world. US President Trump’s posturing on his “America First” theme and the threat of trade wars, ongoing Brexit negotiations which seem destined for a “No Deal”, the U.K. Conservative party’s vulnerability and the potential for a Corbyn led Labour Government, heightened political tensions throughout the Eurozone, US trade sanctions with Iran, tensions in the Middle East and the dark forces of President Putin and Russia.

We could go on but it does feel as though 2018 has seen a sea change in the challenges facing the world. Political risk has overtaken financial and debt risk as the number one fear in Investors’ minds. How then do we at Clarion manage political risk when we construct client investment portfolios?

As always, it is important to separate short term market noise from the real threat facing the world economy and financial markets. For a U.K. based investor the main political considerations are the possibility of a Labour Government, a Brexit “No Deal” and the threat of an escalation in trade tariffs leading to a full blown world trade war.

As such we do not specifically manage political risk in itself because it is binary and could result in a totally different outcome to what was envisaged; it could go either/both ways. By way of example, think about the European referendum two years ago. A lot of investors disinvested in the run up to the referendum, and immediately following the result. These investors were totally wrong footed because of the Brexit vote which caused sterling to weaken, pushing up the value of overseas earnings of large multinational U.K. based companies. The Footsie 100 Index is not really representative of UK Plc because a large proportion, more than 70%, of earnings of large cap companies in the U.K. are derived from oversees. Because of sterling weakness, the value of these earnings, and therefore corporate profitability, were immediately increased by as much as 20% when translated into pounds sterling. The result was an immediate, and significant, upward rerating of the share value of U.K. large cap stocks with overseas earnings.

What was first seen as a possible negative for the U.K. economy, the Brexit vote, turned out to be a positive for the Footsie 100 Index. International investments also benefited from the weakness in sterling pushing up the value of overseas holdings.

However, we are always conscious of political risk, particularly at the moment, with increasing uncertainty about Brexit, the perceived vulnerability of Prime Minister May and the Conservative party and the increasing possibility of a worldwide trade war instigated by President Trump’s “America First” policies.

Equally there are other risks on the horizon; the perception that inflationary pressures are building, rising interest rates, withdrawal of central bank stimulus to name but three. Clarion has therefore been gradually reducing risk in client investment portfolios by:

Our fixed income investments are concentrated towards short dated bonds which are less sensitive to a rise in interest rates and other market risks. Short dated bonds also act as a proxy for cash and provide firepower when markets do fall.

For our UK equity exposure, we are avoiding small and mid-cap stocks which are more exposed to the UK economy. Our UK exposure is tilted towards large cap stocks with significant overseas earnings which will benefit from sterling weakness. In the event of a Brexit “No Deal” and/or the election of a Labour Government sterling is likely to weaken significantly.

We have reduced our exposure to growth type/tech stocks which looked overvalued, particularly in the US, in favour of more value orientated companies with strong balance sheets and visibility of earnings which look undervalued by comparison to growth stocks.

We are under-weight. The USA and have been further reducing US exposure due to valuation concerns, in favour of selected top ups to short dated bonds and small increases in Footsie 100 stocks which will benefit from sterling weakness but, regardless of political risk, which we feel are undervalued compared to other markets.

We remain under-weight Europe because of heightened political risk.

We avoid disinvestment and attempting to “time the market”, an investment strategy which throughout history has been littered with casualties. We firmly believe that it is “time in the market” which provides the best long term returns. Our preference is to be fairly fully invested at all times but to carefully select the appropriate investment to alter the balance between “risk on” and “risk off” as our view of markets and the economies change. Currently we acknowledge that the balance of risk has altered in recent months but we continue to believe the upside risk is higher than the downside risk and therefore a slight tilt toward “risk on” is warranted.