Personal Wealth Management / Market Analysis

A Primer on Political Risk

Breaking down one of stock markets’ primary drivers.

Editors’ note: The following commentary is intended to be nonpartisan. We favor no party, politician or candidate, and believe partisan thinking is dangerous for investors.

When you hear the words, “political risk,” what springs to mind? The risk the other guy or gal beats your favored candidate? Or perhaps the risk the latter wins, only to U-turn on campaign trail promises once in office? Voters face these risks every election—and the fact they frequently come true makes many understandably cynical about the whole enterprise. But for investors, “political risk” means something very different: the risk political forces threaten economic growth and roil markets. Alongside investor sentiment and economic fundamentals, politics is one of stock prices’ three broad drivers. Understanding what political risk is—and isn’t—may help you better size up risks and opportunities in the US and other developed markets. Particularly as US midterms approach and campaign rhetoric heats up, a few pointers may come in handy.

Clearing up some common misconceptions is a good spot to begin, so here is what political risk isn’t. For starters, that post-election policy switcheroo (or compromise) habit mentioned above—it may be frustrating, but it often benefits markets, as it means less radical legislation passes. A certain party winning doesn’t constitute political risk, either. While many associate their preferred party with endless prosperity and the other with certain doom, history shows no party or politician is inherently good or bad for stocks or the economy. Republicans and Democrats alike have presided over bull and bear markets, recessions, recoveries and expansions. There isn’t a meaningful statistical connection between party leadership and market performance in the US or other large democracies. The reason: Policies matter, not politicians—and even policies are just one ingredient in the enormous, complex stew of information stocks process.

Many also fret the lack of a government—a common phenomenon outside the US, where parliamentary systems are the norm. When no party has a majority and hammering out a governing coalition proves time-consuming or impossible (which can trigger a snap election), nothing happens outside of a caretaker government overseeing basic functions like the budget. But this can actually be a boon, as it typically eases political risk for a while (more on this below). For example, Belgium went 589 days without a government in 2010 – 2011—a world record. The eurozone debt crisis and accompanying regional bear market struck during this time, dragging down Belgian stocks by -10.9%.[i] During that period, however, eurozone stocks dropped -17.4%.[ii] Similarly, when the Netherlands went 225 days without a government in 2017, Dutch stocks rose 21.3%—doubling the MSCI World and further demonstrating markets don’t mind going without a government for a while.[iii]

Personal drama and headline-grabbing scandals among a country’s leadership are another bogeyman with questionable market relevance. News coverage may follow every turn breathlessly, but stocks often tune it out. Case in point: While South Korean politics took a bizarre turn in late 2016 – early 2017—culminating in the president’s ouster—Korean stocks initially dipped, then rose choppily throughout the impeachment and new election process. Similarly, during President Clinton’s impeachment circus in 1998 – 1999, the S&P 500 endured an unrelated correction (tied to the Asian financial crisis) but overall rose nearly 30% in price terms.[iv] Thus, it is imperative to follow the above Editors’ Note to the letter. Partisan bias is blinding and leads many investors to make ideologically driven choices that threaten their long-term goals. To refocus on what matters, consider these three genuine political risks.

A Unified Government

A government with a strong majority and internal unity raises the likelihood of radical legislation passing. Stocks typically don’t like this—major reforms create winners and losers, and the latter are especially upset. Major legislation also stirs worry—firms wonder who the victim will be when property rights change next. This fear can discourage risk-taking as business owners and investors wait for the next shoe to drop. But while stocks prefer gridlock, they don’t automatically tank when one party sweeps into power. The uncertainty boost may be one headwind, but other positives can outweigh it.

Thriving Bipartisanship

This sounds ideal for stocks—across-the-aisle compromises produce milder change, right? While plausible in theory, this doesn’t hold true in practice—there have been some big bipartisan bombs over time. Like Sarbanes Oxley (2002), which saddled public companies with massive regulatory and liability burdens and likely contributed to the 2000 – 2002 bear market’s double-bottom. While intended to correct Enron-type excesses, it primarily imposed huge costs—reducing profits and even discouraging many firms from going public. It passed 423 – 3 – 8[v] in the House and 99 – 1 in the Senate. Looking further back, the Economic Stabilization Act of 1970 gave President Richard Nixon the power to enact damaging price controls—which he later used. This also passed with overwhelming House and Senate majorities. Thus, while not especially common—partisan rancor seems to be the norm—a collaborative Congressional atmosphere isn’t reason for investors to celebrate.

An Aggressive or Secretive Regulatory Environment

Since Congress frequently delegates rulemaking to executive agencies, they make all kinds of de-facto laws. This produces a phenomenon we call “government creep”—the tendency for these agencies to gain and wield power in increasingly expansive ways. Crucially, they aren’t always subject to the same transparency requirements—nor the same limelight—as Congress. Hence, they often craft rules behind closed doors without public comment—or issue novel interpretations of existing rules. Both undermine markets’ ability to gradually price in potential changes. Compare this to the Congressional sausage-making process, where the debates are public, noisy and subject to plenty of media scrutiny. Heck, they frequently even air on live television.[vi] Stocks generally prefer this, as do businesses. Presently, this phenomenon is more of a latent risk than a clear and present danger for stocks.[vii] If it escalates, though, there is a risk aggressive new rules could blindside markets.

In Emerging and Frontier economies with more fragile political institutions, this issue can take a slightly different form. The executive may attempt to encroach on the judiciary or legislature’s turf—or, as occurred recently in Turkey and Argentina, threaten the central bank’s independence. Occasionally this is simply sociology, but if markets suspect the rule of law is giving way to arbitrary, centralized authority, they may grow antsy. This is an important political risk for investors in developing nations to consider. In developed countries, this risk is less common—but shenanigans aren’t unheard of. Nixon, for example, pressured then-Fed Chair Arthur Burns to keep monetary policy loose—and FDR tried to pack the Supreme Court with a passel of new judges who wouldn’t keep ruling his New Deal legislation unconstitutional. But no actions like these appear to be on the horizon today.

A final note of caution: Always consider political factors alongside economic and sentiment drivers—plus how they shift and interact. No stock driver is an island. Presently, forward-looking indicators like money supply, yield curves and business surveys suggest the global economy is poised to keep growing, while sentiment is broadly warming but not overstretched. In concert with the gridlock currently prevailing in most developed-world governments, we believe signs point to more bull market ahead.

[i] Source: FactSet, as of 6/15/2018. MSCI Belgium Index with net dividends in USD, 4/26/2010 – 12/6/2011. -7.9% in euro.

[ii] Ibid. MSCI European Economic and Monetary Union Index with net dividends in USD, 4/26/2010 – 12/6/2011. -15.6% in euro.

[iii] Ibid. MSCI Netherlands Index with net dividends in USD, 3/15/2017 – 10/26/2017. +10.2% in euro. The MSCI World rose 10.6% in USD, 0.5% in euro including net dividends, 3/15/2017 – 10/26/2017.

[iv] Ibid. S&P 500 Price Index, 1/17/1998 – 2/12/1999. The first date is when news of the scandal initially broke. The second is when Clinton was acquitted.

[v] This last number is abstentions.

[vi] C-SPAN—ready and waiting in case you need a break from World Cup thrills.

[vii] The Consumer Financial Protection Bureau under former director Richard Cordray had a penchant for unleashing unexpected rules many believed overstepped the agency’s already broad powers. But it is now under new, less zealous management.

If you would like to contact the editors responsible for this article, please message MarketMinder directly.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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