Download Political risk: what market impact

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
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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
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Head of Global Market Research
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Cross-Asset Strategist
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