Investment Institute
Macroeconomic Research

Investing and volatility: Political risk in perspective

  • 06 April 2022 (5 min read)

Without a doubt, over the past two years investors have had to tolerate – and navigate – a hefty amount of market volatility. The primary driver has been the coronavirus pandemic, but more recently the onset of tighter monetary policy and Russia’s invasion of Ukraine has ushered in a fresh wave of uncertainty.

Russia’s actions will likely have a significant economic, as well as human, cost. The escalation of political tensions into military conflict triggered a sell-off in global stock markets and sent the price of oil above $100 a barrel for the first time in seven years. As well as market volatility in the short term, there are potential implications for global energy supplies, the path of inflation and interest rates and more.

Geopolitics and international relations have always had a major influence on financial markets and investment performance – from a lack of clarity in public statements from senior politicians, to ongoing trade wars, or at the other end of the spectrum, military conflict. History has highlighted on a plethora of occasions that investors dislike uncertainty. This is especially true when it’s the result of political, or monetary policy, rhetoric and wrangling - the words and actions of politicians and policymakers can, and do, have an impact on markets.

Politics and political rhetoric

The temptation to cash out at the first sign of trouble can result in investors crystallising their losses and potentially missing out on any subsequent recovery. For investors with a stronger constitution and higher long-term risk threshold, bouts of short-term volatility – whether driven by politics or not - can offer the opportunity to pick up high-quality assets at a discount.

For example, what occurred in 2020 was unprecedented, but despite the market swings, global shares ended the year 16.5% higher as the development of vaccines and the impact of unprecedented government and central bank stimulus helped buoy sentiment.1 Equally in May 2021, US Treasury Secretary Janet Yellen sparked a global market sell-off after warning US interest rates may have to rise to stop the economy overheating, although she later sought to reassure investors that she saw no inflation problem on the horizon.2 But again, stocks enjoyed strong gains in 2021 with the MSCI World index finishing the year 22.4% ahead.3

And nearly a decade ago, in 2013 former Federal Reserve chair Ben Bernanke sent US Treasury yields soaring, during the now infamous ‘taper tantrum’, when he announced the central bank would stop its bond buying programme. But once the initial consternation eased, the market recovered.

If we look at the military events of the past 50 years - and while past performance should never be viewed as a guide to future returns, we can learn some interesting lessons about volatility. After the Iraq invasion of Kuwait in 1990 the market had rebounded within four months; after the terrorist attacks in the US on 11 September 2001, it took the market three weeks to recoup its losses.4

Key elections could cause further upset

Political risk is not going away anytime soon. This year will see key elections take place across developed and emerging markets. All of these, and more, could potentially rattle investors’ nerves.

The US mid-term elections take place this November, with the primaries process having already started in March. More than a third of Senate seats and all 435 voting seats in the House of Representatives, as well as several high-profile state governor seats, will be contested.5

In many emerging markets, election years have coincided with a boost in fiscal spending, which has often led to a significant deterioration of already fragile fiscal positions, which can put pressure on currencies and bond yields.6 Financial and political cycles have decoupled somewhat as emerging markets see their democracies mature, but with several key elections coming up in 2022, markets are likely to be sensitive to political events.

Potentially controversial elections loom in Latin America, with Brazil and Colombia and Costa Rica all going to the polls while Chile will hold a plebiscite on a new Constitution. Meanwhile Colombia recently held congressional and presidential primaries, yielding mixed results for the country’s political and economic outlook. And in Peru, political noise is ramping up again, after the country’s Congress approved an impeachment trial against President Pedro Castillo. In Asia, elections in the Philippines in May need to be monitored for shifting policy direction while in Europe, Serbia has an important electoral year. And in October 2022, China holds its 20th Party Congress – perhaps the most important political event in China, that takes place once every five years.

Climate change

Climate change is increasingly viewed as a geopolitical issue, with investors paying close attention to government policy and programmes, particularly in the run-up to and following the United Nations environmental summit COP26 in November 2021. The shift to a carbon neutral world will have an impact on how governments allocate budgets, with several studies warning that countries do not currently have adequate funding in place, which could have ramifications for everything from tax increases to reallocating capital away from other sectors to governments issuing more green bonds.

In addition, there is the risk that countries that are not perceived as doing enough in the transition to net zero could see their bonds shunned by investors.

Volatility can provide opportunity

What’s clear is that political events and decisions will always drive volatility in financial markets, to varying degrees. For investors with a stronger constitution and higher long-term risk threshold, bouts of short-term volatility can offer the potential opportunity to pick up high-quality assets at a discount.

As such we believe it makes senses for investors to remain focused on their long-term investment goals, as opposed to getting caught up in short-term market panic.

Diversifying across asset classes can be potentially beneficial. While maintaining a well-diversified portfolio cannot guarantee against losses, it can aim to maximise returns – and minimize losses – by investing in different asset classes that may not move in the same direction at the same time. This could potentially help to smooth the impact of volatile markets for investors who take a long-term approach.

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