In the latest edition of Global Horizons, Stephanie Kelly, Political Economist, outlines SLI’s analytical framework for assessing the factors that drive political risk and the potential consequences for investors. By identifying risk factors within two distinct categories, institutional and cyclical, it is possible to identify the key drivers of political risk events and build an investment view that takes these factors into account. The framework is especially useful for examining the key political events of 2017 and considering how likely they are to deliver further shocks to the status quo.

Executive summary

  • Following a year of unexpected political events in advanced economies on both sides of the Atlantic, investors have become more aware of the impact of political risk on market outcomes. In this paper, we set out an analytical framework for assessing the drivers of that risk. We highlight how institutional risk factors shape the way political systems function, lay the foundations for economic and financial market activity, and interact with cyclical factors that influence government stability and the frequency of risk events.
  • Using this framework, we identify electoral risk as a key form of political risk that played a leading role in market volatility in 2016 in the US, UK and Europe. We define the key variables that drive electoral risk, including the nature of the electoral system, voter ideology and polling accuracy. Our analysis shows that electorates in the advanced economies have become more fragmented and polling has become less accurate over the past three years; right-wing populist parties in particular have confounded pre-election opinion polls.
  • Recent elections in Spain, Portugal and Ireland illustrate how political risk factors can lead to delayed and unstable government formation, creating heightened policy uncertainty and inefficient policymaking. Our econometric analysis shows that sustained increases in generic policy uncertainty can have meaningful effects on economic and market activity, although the impact can vary significantly across countries. In particular, GDP growth, equities and the real exchange rate in Europe appear to be more sensitive to economic policy uncertainty shocks than their US counterparts.
  • In the presence of political risk, scenario analysis is an effective tool for considering the consequences of different political outcomes. In the case of the US election, our pre-election scenario analysis showed that individual and corporate income tax cuts were a likely consequence of Donald Trump winning the presidential election and Republicans retaining control of both the House of Representatives and the Senate. However, it also pointed to potential conflicts in other areas of policy as the president’s populist agenda rubbed against traditional congressional Republican priorities. Investors initially reacted favourably to the election result but tail risks from anti-growth trade and immigration policies remain acute.
  • Our political risk framework and empirical findings can also be applied to the European elections that will take place in 2017. In France, the two-round French presidential system makes it difficult for non-centrist parties to win elections, but a surprise win for Marine Le Pen has the potential to create an existential crisis for both the Eurozone and the European Union. The German federal election, which is due in September, carries comparatively less risk. This is due to the smaller levels of support for right-wing populist parties, the country’s history of centrist coalition building and the fact that the most probable alternative to a Merkel-led government is an even more pro-European Social Democratic-led coalition government.
  • Although national elections are not due in Italy until 2018, snap elections are possible after Matteo Renzi resigned in the wake of his defeat in December’s constitutional referendum. The rise of the populist Five Star Movement is keeping investors up at night, but changes to the electoral system are a moderating factor. Meanwhile, the Netherlands election has been flying below the radar somewhat. More generally, the probability that one of these European political risk events crystallises this year appears to be underestimated by investors.

Risky business

Many of the major market-moving events in the advanced economies during 2016 were politically driven: the UK referendum on EU membership, the US presidential election and the Italian constitutional referendum. Political uncertainties also cast a shadow over 2017 as investors weigh up the implications of a Trump presidency, the French presidential election, the German general election and the commencement of Brexit negotiations. Investors are more aware than ever of the powerful effect that these kinds of political events can have on economic and market outcomes, and the dangers of assuming that the status quo will be maintained. We have therefore developed an in-house framework for assessing political risk.

Our starting point is to adopt a simple taxonomy of political risk for investors, based on research into best practice in political risk analysis (see Figure 1). For investors, political risk is ostensibly the threat of a market-unfriendly outcome as a result of political factors. From an investment point of view, bottom-up investors (micro) and top-down investors (macro) are exposed to the same factors that drive political risk but the triggers within these categories can be different. Within both investor groups, there are two major aspects to consider when analysing political risk: institutional and cyclical. By understanding the institutional and cyclical factors driving a potential political risk event, investors can build their investment view taking into account political risk in a structured, holistic way.

Institutional risk factors arise from the structure of political and legislative institutions of a particular country. These can be internal (strength of institutions) or external (strength of transnational political constraints, e.g. EU membership). The factors that are widely incorporated into political risk scores produced by private and public research firms mostly fall into this subset. These ordinarily include voice and accountability, political stability and absence of violence, government effectiveness, quality of regulation, rule of law and control of corruption. The features of a country’s electoral system also deserve explicit mention: the voting system (proportional representation, first-past-the-post), election frequency as specified in legislation, the historical structure of governments (e.g. coalitions, majority, minority governments), historical voter turnout and historical polling accuracy all warrant inclusion as key institutional risk factors for investors. These components serve to lay the groundwork as to the type of country an investor is dealing with based on long-term, fairly static data and form the political foundation for economic and market performance.

Cyclical factors incorporate the time-sensitive, day-to-day aspects that contribute to political risk. Within this risk class, we identify three principal categories: elections, procedures and country rating. The former refers to the period of time until Election Day, election outcomes and government formation. As Election Day approaches, political uncertainty can be heightened as the risk that the outcome will be market-unfriendly becomes more immediate. The procedural factor refers to events that occur as a result of legislative negotiation and parliamentary policymaking. A number of aggregate political risk scores from private political risk firms also incorporate temporal risks along the same lines as these cyclical factors.

Critically, these political risk factors also interact and reinforce one another. Institutional factors provide the foundation upon which cyclical factors wax and wane; the stronger the institutional factors, the less extreme cyclical factors will tend to be in absolute terms. This is why advanced economy political risk on the whole tends to be lower and less volatile than in emerging markets, where the

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