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Political risk: what market impact ? INVESTMENT STRATEGY REPORT 26 August 2016 The referendum on Brexit marked a comeback of political risk, driving the European political uncertainty index to all-time highs. After a summer break, we will probably see further pressure in the near future in Europe (Italy), and in the United States in the run-up to the presidential elections. In this paper, we assess the "market" impact of political risk, i.e. the impact of a rise in political risk on the risk regime and on assets’ return. We expect a marked increase in political risk over the coming weeks, and therefore a rise in volatility in the markets. Changes in “specific” risk will without doubt be a factor for arbitrage between European and US assets. In this respect, we believe European risk is the major risk, which is likely to cause a real, potentially long-lasting risk aversion shock. Marketing communication: This document has not been developed in accordance with legal requirements designed to promote the independence of investment research and its author(s) is/are not subject to any prohibition on dealing in the relevant financial instrument ahead of the dissemination of the marketing communication. Political risk 450 Etats-Unis Europe 450 400 400 350 350 300 300 250 250 200 200 150 150 100 100 50 0 50 Sources : Fed Saint Louis, Datastream, NATIXIS 0 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15 Political risk and equity volatility VIX EPU-US 50 250 40 200 30 150 20 100 10 50 0 Sources : Fed Saint Louis, Bloomberg, Natixis 0 90 92 94 96 98 00 02 04 06 08 10 12 14 16 Nathalie Dezeure Tel. +33 1 58 55 99 93 [email protected] Florent Pochon Tel. +33 1 58 55 23 81 [email protected] www.research.natixis.com CORPORATE & INVESTMENT BANKING INVESTMENT SOLUTIONS & INSURANCE SPECIALIZED FINANCIAL SERVICES Distribution of this report in the United States. See important disclosures at the end of this report. INVESTMENT STRATEGY REPORT Measuring political risk and its recent trend Political risk, i.e. the transparency of economic policies, took on a new dimension with the 2008 crisis. Faced with a new kind of systemic and global shock, monetary authorities have implemented new instruments, multiplying unconventional measures. At the same time, budget balances have deteriorated, and not only in the euro zone, triggering new crises (Greece, Spain, Portugal). Political risk is by definition difficult to measure. We will here use the EPU (Economic Policy Uncertainty) indices published by the St. Louis Fed and based on work by Baker, Bloom and Davis1. These indices are calculated on the basis of a simple textual analysis (counting the frequency of key words) carried out on the main daily newspapers, and aim to capture political uncertainty. These indices are broken down by geographical zones according to the press universe used. The chart below represents the US and European EPU indices since 1985, and shows that the indices share a very significant common component, which is hardly surprising given the methodology used to build the indices. We make the same observation for the intra-euro zone indices, where the indices are very closely correlated. However, while the US index returned to a "neutral" level in 2013-2014, the trend in the European indices rather seems to indicate a more enduring regime change since the euro-zone crisis in 2011, with a structurally higher average index. Economic Policy Uncertainty Index - United States vs Europe 450 United-States 450 Europe 400 400 350 350 300 300 250 250 200 200 150 150 100 100 50 50 Sources : Fed Saint Louis, Datastream, NATIXIS 0 0 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15 The sensitivity of political risk is currently high because of several factors: i/ the room for manoeuvre in terms of economic policies is very limited; ii/ uncertainty about future decisions is maintained by the fact that institutions are being called into question, by the growth in alternative political forces and by partisan stalemates. These factors explain the trend increase in political risk from end-2015 to the shock of the result of the Brexit referendum on 24 June. This led the European EPU index to hit an all-time high, well above levels seen during the various episodes of the crisis in the euro zone. Note that France and Germany, the countries at the core of the European construction, have been particularly affected. This increase in uncertainty has also spread to the United States. 1 Baker S., Bloom N., Davis S.J. (2015) “Measuring Economic Policy Uncertainty”, NBER Working Paper 21633. The index is available at http://www.policyuncertainty.com/. 2 INVESTMENT STRATEGY REPORT EPU - Europe (100= January 2015) United-Kingdom Spain Germany 400 France Italy Europe 350 300 250 200 150 100 50 1/1/15 1/4/15 1/7/15 1/10/15 1/1/16 1/4/16 1/7/16 Sources : Datastream, NATIXIS After a rapid normalisation, new pressure is likely to appear over the coming weeks. In addition to Brexit, which remains a key issue in terms of how the exit will take place and the institutional consequences for Europe and the United Kingdom (Scotland and Ireland), other events indicate that the autumn will be more turbulent, culminating with the Italian referendum in November and the US elections (on 8 November). What impact of political risk on the markets? We here try to assess the "market" impact of political risk, i.e. the impact of a rise in the EPU on risk aversion (RPI) and the return on assets. To this end, we identify episodes of pure political risk, i.e. periods for which the triggering factor is political/institutional. We then look at their impact on the market risk with the help of the Natixis Risk Perception Index (RPI below) and particularly their propensity to move the markets to a high-risk regime, which we here define as a risk perception index (RPI) in excess of 0.7. Insofar as the US and European indices move in tandem and taking into account the availability of data (the US index is available in daily data, which is not the case with the European index), we here look at the EPU-US. In all cases, a rise in the EPU-US results in a more or less pronounced resurgence of volatility. In contrast, it does not necessarily lead to a change of risk regime. EPU and equity volatility 800 80 EPU-US, G VIX, D 70 600 60 50 400 40 30 200 20 10 0 0 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 Sources : Fed Saint Louis, Bloomberg, NATIXIS 3 INVESTMENT STRATEGY REPORT The chart below compares the EPU-US and periods of high risk aversion. We mainly note two things: 1. A high political risk is not systematically accompanied by a rise in the RPI, as shown by the Gulf War (spring 2003), the US fiscal cliff (end-2012), and the US shutdown episode (October 2013); 2. Factors that in principle are exogenous (financial and/or geopolitical crises) may have a marked impact on political risk. EPU and risk perception RPI, Rhs EPU-US, Lhs 800 9/11 700 1.00 Debt ceiling Euro crisis/contagion 0.95 US Elections Obama 600 Gulf war 500 300 0.90 Lehman US & TARP stimulus debate Euro crisis/Greece Russia crisis 400 n/LTCM Fiscal Cliff US Elections nov. 2000 Brexit US Gov. Shutdown 0.85 0.80 200 0.75 100 0 0.70 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 Sources : Fed Saint Louis, NATIXIS Lastly, we identify mainly five episodes of "pure political risk" that have triggered a sharp rise in risk aversion and, consequently, a marked reaction by financial assets (charts below): The US elections in November 2000, The US elections in November 2008 (Obama) ("Opinion Polls and the Stock Market: Evidence from the 2008 U.S. Presidential Election"), The euro zone crisis - episode 1 "the sovereign crisis in Greece", spring 2010, The euro zone crisis - episode 2 "contagion: Portugal" and the debate on the US debt ceiling summer 2011, The referendum on Brexit in June 2016. The following charts show the trends in the main financial assets during these political risk phases. Return on assets (total return) and political risk US elections -2000 5.0 S&P 500 TOPIX US GOVT. INDEX DXY index US elections -2008 EURO STOXX EMERGING MARKETS Index EMU GOVT. INDEX 5.0 2.5 2.5 0.0 0.0 -2.5 -2.5 -5.0 -5.0 -7.5 -7.5 -10.0 EURO STOXX EMERGING MARKETS Index EMU GOVT. INDEX 15 10 10 5 5 0 0 -5 -5 -10 -10 -15 -15 -20 -20 -10.0 -25 -12.5 -30 3/11/08 Sources : Datastream, NATIXIS -12.5 7/11/00 12/11/0017/11/0022/11/0027/11/00 2/12/00 7/12/00 12/12/0017/12/00 15 S&P 500 TOPIX US GOVT. INDEX DXY index -25 Sources : Datastream, NATIXIS 8/11/08 13/11/08 18/11/08 23/11/08 28/11/08 -30 3/12/08 4 INVESTMENT STRATEGY REPORT EZ crisis / season 1 - 2010 S&P 500 TOPIX US GOVT. INDEX DXY index 10 EZ crisis / season 2 - 2011 EURO STOXX EMERGING MARKETS Index 10 EMU GOVT. INDEX 5 5 0 0 EZ crisis / season 2 - 2011 -5 -5 -10 -10 -15 -15 8/5/10 EURO STOXX EMERGING MARKETS Index EMU GOVT. INDEX 10 5 5 0 0 -5 -5 -10 -10 -15 -15 -20 -20 -25 Sources : Datastream, NATIXIS -20 3/5/10 S&P 500 TOPIX US GOVT. INDEX DXY index 10 -25 Sources : Datastream, NATIXIS 13/5/10 18/5/10 23/5/10 28/5/10 2/6/10 7/6/10 -20 12/6/10 -30 22/7/11 -30 27/7/11 1/8/11 6/8/11 11/8/11 Referendum /Brexit S&P 500 TOPIX US GOVT. INDEX UK GOVT. INDEX 10.0 EURO STOXX EMERGING MARKETS Index EMU GOVT. INDEX DXY index 10.0 7.5 7.5 5.0 5.0 2.5 2.5 0.0 0.0 -2.5 -2.5 -5.0 -5.0 -7.5 -7.5 -10.0 -10.0 Sources : Datastream, NATIXIS -12.5 23/6/16 -12.5 28/6/16 3/7/16 8/7/16 13/7/16 18/7/16 The reaction to the result of the Brexit referendum was both drastic and fleeting (only two trading sessions of fall followed by a correction). The table below summarises the reaction of certain assets during these different episodes of high political risk. On average over the periods considered, equities lost close to 10% in an interval of 15 days and the dollar DXY benefited from its safe-haven status in all cases. Change in assets (total return) during phases of acute political risk and high-risk regime S&P500 EUROSTOXX TOPIX EM-Market US GOV. INDEX EMU GOV. INDEX UK GOV. INDEX DXY INDEX 15-day change US elections-2000 -5.7 -3.6 -6.5 -4.4 1.5 0.7 1.9 1.2 2010- EZ crisis (1) -10.5 -8.4 -10.8 -11.0 2.3 1.9 2.9 4.8 2011- EZ crisis (2) & US debt ceiling -12.7 -19.1 -11.3 -13.2 2.8 2.8 4.0 0.6 Avg. -9.7 -10.4 -9.5 -9.5 2.2 1.8 2.9 2.2 2.4 largest decreases on a 15-day interval US elections-2000 -7.6 -6.5 -7.8 -6.3 1.7 0.7 1.9 2010- EZ crisis (1) 2011- EZ crisis (2) & US debt ceiling -10.7 -8.4 -10.9 -11.8 2.3 1.9 3.0 5.9 -16.7 -21.5 -11.3 -14.6 3.6 2.8 4.0 1.2 2016- Referendum/Brexit -5.3 -10.9 -7.3 -4.1 2.4 2.1 7.0 3.3 Avg. -10.1 -11.8 -9.3 -9.2 2.5 1.9 4.0 3.2 Sources: Natixis, Datastream The next rounds of elections, in Italy with the referendum on the constitutional Senate reform in November (the date has not been set yet) and the elections in the United States will generate new pressure on political risk, without mentioning 2017 and the large number of general elections in Europe. However, while the effects on the EPU are certain (by construction), they do not necessarily create a strong market reaction. 5 INVESTMENT STRATEGY REPORT "Specific" risk and relative performance of US-Euro assets The Italian question does not seem to be a factor of major political uncertainty at present: the EPU-Italy actually fell to a relatively low level in July after peaking in June, linked to the referendum on Brexit. Nevertheless, a "no" at the referendum would lead to Matteo Renzi’s resignation (see What if Matteo Renzi lost the referendum on the Senate?) and would cause a new period of political uncertainty in a context where Italy’s euro-zone membership would be called into question if the Five Star Movement came to power. In spite of the safeguards put in place in the euro zone, this would have a significant impact on the markets because of investors’ exposure to Italian sovereign debt and the return of the risk of a break-up of the euro zone. As for Europe, the Italian risk could create the greatest shock since the 2011 crisis and would open a new chapter in the euro-zone crisis. Such a scenario would obviously have major impacts on EUR assets by comparison with USD assets. Given the significant common component between the US and European EPU indices, we here estimate the specific share of European political risk as the European EPU index filtered from the EPU-US index. We see that this European "specific" risk (positive filtered component) tracks the relative performances of equity and bond assets against US assets. A rise in the European "specific" risk leads to an outperformance of European bonds (Bunds) against T-Notes, and an underperformance of European equities. 1.2 1.1 1 300 Relative performance Bund vs. US-T Notes (TR) European "specific "risk 8 250 7 200 150 0 0.7 Sources : Datastream, NATIXIS 0.6 -100 -150 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15 Political risk and US elections 200 100 50 4 -50 250 150 5 50 0.8 European "specific" risk 6 100 0.9 300 Relative performance S&P500 vs Stoxx (TR) 0 -50 3 Sources : Datastream, NATIXIS 2 -100 -150 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15 In terms of the US elections, there is a twofold risk of a rise in the EPU. First, we traditionally see pressure in the run-up to the elections. In this respect, the trend in the EPU-US since early July is in line with those seen during previous elections. EPU-US in pre-electoral periods (July-November, 1 July = 100) Average 2008 450 1988 2012 1992 2016 2000 1996 400 2004 Elections (between 2 and 8 November) 450 400 350 350 300 300 250 250 200 200 150 150 100 100 50 50 0 0 1/7 1/8 1/9 1/10 1/11 Sources : Fed Saint Louis, NATIXIS 6 INVESTMENT STRATEGY REPORT Second, the presence of an atypical Republican candidate (Donald Trump) is an additional factor of uncertainty that could trigger a sharper rise in the EPU than the average seen during previous elections. While this risk is less relevant at present (if we are to believe the polls that predict a comfortable victory for Hillary Clinton), it could nevertheless resurface in the run-up to the elections. Furthermore, the results of the Congress elections will also be an important factor insofar as they will determine the leeway of the future president of the United States. Lastly, as shown by the following chart, we should also note that uncertainty often picks up again after the elections, in early January (first trading session of the new Congress) and end-January (handover of presidential powers). EPU-US pre- and post-elections EPU-US: average over the last seven US-elections 250 250 Average pre (-5 months)/post (+5 months) elections 2016- EPU since 07/1 200 200 150 150 100 100 50 50 Sources : Fed Saint Louis, Natixis 0 0 1/7 1/8 1/9 1/10 1/11 1/12 1/1 1/2 1/3 1/4 The EPU-US - and therefore volatility - is likely to increase noticeably in the run-up to the elections (as well as when Congress and the president take power). A study undertaken on a sample of 27 countries2 shows in particular that volatility increases noticeably in the days preceding the election. It also shows that investor reaction (volatility) is stronger when i/ the results are tight, ii/ they lead to a change of political agenda, iii/ the government does not obtain a parliamentary majority. These factors combined with the atypical character of the Trump/Clinton duel (which goes beyond traditional bipartisanship) and the coherence of the programmes suggest that uncertainty (EPU) could be markedly higher than during previous elections. Conclusion: An inevitable return of volatility We are likely to see a marked increase in political risk over the coming weeks, in the United States as in Europe, as the US and European EPU indices share a very significant common component. This will have an impact on the markets, on volatility (which is currently extremely low) and possibly on the risk regime and therefore on asset allocations. Changes in specific risk will without doubt be a factor for arbitrage between European and US assets. In this respect, we believe European risk (referendum in Italy, rise of anti-European Union parties everywhere in Europe) is the major risk, which is likely to cause a real, potentially long-lasting risk aversion shock. In principle, we see the risk associated with the US elections as lower, as the promises made by the candidates will be "filtered" by Congress, with the exception of uncertainties concerning the stance of monetary policy (including exchange-rate policy) in the event of a victory for Donald Trump. 2 Bialkowski J., Gottschalk K., Wisniewski T. , 2008 « Stock market volatility around national elections », Journal of Banking & Finance, Vol.32, Issue 9. 7 INVESTMENT STRATEGY REPORT Multi Asset Strategies Head of Global Market Research Christophe Ricetti +33 1 58 55 05 22 [email protected] Multi Asset Strategies Research Head of Multi Asset Strategies Research Evariste Lefeuvre +1 212 891 6197 [email protected] Rates & Forex and Investment Strategy Research Head of Rates & Forex and Investment Strategy Jean-François Robin +33 1 58 55 13 09 [email protected] Investment Strategies Cross-Asset Strategist Cross-Asset Strategist Cross-Asset Strategist Nathalie Dezeure Florent Pochon Emilie Tetard +33 1 58 55 99 93 +33 1 58 55 32 81 +33 1 58 19 98 15 [email protected] [email protected] [email protected] EM Strategist Fixed Income Strategist FX EM Strategist Lysu Paez Cortez René Defossez Nordine Naam +33 1 58 55 80 97 +44 20 321 692 18 +33 1 58 55 14 95 [email protected] [email protected] [email protected] Rates Strategist Rates Strategist Cyril Regnat Jean Christophe Machado +33 1 58 55 82 20 +33 1 58 55 51 79 [email protected] [email protected] Cross-Asset Strategist Su Young Lee +1 212 891 5799 [email protected] Rates & Forex Technical Analysis Modelisation/Stress tests Technical Analyst Strategist Micaella Feldstein Maryline Perrinet +33 1 58 55 80 83 +33 1 58 55 40 77 [email protected] [email protected] 8 INVESTMENT STRATEGY REPORT Disclaimer Reference prices are based on closing prices. 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