Europe: Managing geopolitical risk
European investors face an unprecedented array of political risks over the next few months. Daniel Ben-Ami reports
Long gone are the days when investment managers, at least in the developed western world, can ignore geopolitical risk. The time when political instability was mainly a question for emerging market investment seems to have vanished. Politics has moved centre stage in both North America and Western Europe.
A recent survey of almost 1,500 members of the CFA Institute, a global association of investment professionals, supports this point. It found 70% expected investment returns to be compromised by geopolitical uncertainties over the next three to five years.
Whereas last year the focus was on the main Anglo-Saxon countries – with the EU referendum in the UK and the presidential election in the US – this year it has shifted to continental Europe. The consensus is that France, with the possibility of the election of the National Front’s Marine Le Pen as president, poses the greatest risk. But the recent Dutch election was a cause for concern as are the upcoming federal elections in Germany. In the Federal Republic the eurosceptic Alternative für Deutschland is highly unlikely to join the next government after the September elections but it could gain influence.
Nor are the upcoming elections the entire story. Italian politics is in disarray at present. The ruling Democratic Party seems to be crumbling while the next largest party is the eurosceptic Five Star Movement (5SM). Although the next general election is due to be held no later than May 2018, there is a chance it could happen earlier. Meanwhile, Greece is due to make another debt repayment this summer.
There is even a possibility that the euro-zone could start to break up completely. European policymakers are no doubt intent on holding it together but the possibility of the situation spinning out of control cannot be ruled out entirely.
Lukas Daalder, the CIO of Robeco Investment Solutions, says: “As long as you’ve got the powers that be with their noses facing in the right direction the risk of a break-up of the euro is pretty limited.” The risk is that a Le Pen victory could shift the balance. “It would be a game-changer; you would have a head of state who is anti-EU.” This is despite the fact that, as he acknowledges, the French parliamentary elections will not be until June and the National Assembly has substantial political power.
Klaus Kaldemorgen, a fund manager at Deutsche Asset Management, agrees that a Le Pen victory poses a risk but sees it as unlikely to materialise. The French electoral system means she would need to win an absolute majority in the second ballot. Nor would a Le Pen victory necessarily lead to France’s exit from the euro-zone. “The cost of leaving the region would be much higher than that of Britain leaving the EU,” he says.
Both Daalder and Kaldemorgen are closely watching developments in Greece even though no more money is likely to be pledged until after the French election. Kaldemorgen says he hopes to see a political solution to the Aegean state’s problems. “The last thing we need is a confrontation with Greece.”
Bob Baur, the chief global economist at Principal Global Investors, takes a different tack. He sees Europe as facing a tricky combination of economic and political challenges. “Is the problem really that Le Pen is doing so well?” he asks. “Or is it that there are groups of people throughout Europe who are disenfranchised, have had stagnant incomes for some time and are a bit disillusioned with the whole idea of being ruled by some unelected bureaucrats in Brussels?”
However, in his view the recent pick-up of the global economy after a years of poor performance provides hope. “I think we are in a sizeable transition out of a decade of economic morass,” Baur says. He points out that World Bank figures show there was a global recession in 2015, if calculated in dollars. In his view, several factors were responsible for economic sluggishness, including the end of both the investment cycle in China and debt-driven consumption in the West.
The converse of this argument is that the recovery should help mitigate geopolitical risk. “A very positive economic environment can take you through political problems,” he says.
Italy is his main concern in Europe. He is worried by the alleged corruption and the possibility that the 5SM could govern.
For European fund managers this complex pattern of instability poses risks for their portfolios as well as opportunities. It also involves decisions about the appropriate course of action.
For those with global portfolios the decision is relatively straightforward. If they are seriously concerned about European geopolitical risk they can reduce their holdings in the region. On the other hand, if they think the worry is overdone they can increase their holdings.
Fulcrum, a specialist investment manager with a top-down global approach, is maintaining a low exposure to European equities at present. Emma Halley, a director of the firm, points out that confident geopolitical calls have proved wrong over the past year. “The one thing we can learn from Trump and Brexit is that the outcome is not always what you always think it will be prior to the event,” she says.
Fulcrum’s approach is not to predict outcomes but to protect its portfolios against adverse events. “It is a key policy of our strategy to have hedges in place for these large macro risks.”
In relation to the European portions of its portfolios, this can involve taking positions on the currency as well as the main asset classes. For example, at the time of writing it was short the euro against sterling, short in French government bonds relative to Bunds and had an equity put spread in position.
In contrast, those with specifically European portfolios do not have the option of reducing their regional holdings. Not everyone has such flexibility in the use of derivatives either.
Robeco’s Daalder describes his approach to protecting his portfolio against geopolitical risk as a balancing act. “You try to look for trades that don’t cost you too much if things go right, so if Le Pen doesn’t win, but give you the insurance premium if things go wrong.”
Part of the process is assessing whether current market levels accurately reflect the level of political risk. If the markets are too poorly priced it could reflect an overly pessimistic assessment of the risks involved.
For him, the euro is particularly important to consider. For example, if Le Pen wins, the currency could be affected more than equity prices. “Your protection comes from the fact the euro will suffer and, therefore, earnings calculated back to euros are likely to be partly compensated by that factor,” he says.
Kaldemorgen concedes that a Le Pen victory would probably hit the euro in the short run. However, he argues that an exit of weaker economies from the euro-zone would probably benefit the currency bloc in the longer term.
“I imagine that after a few days of panic in the market the rest of the world will realise that the remaining countries that still have the euro will be stronger rather than weaker.”
In a few months’ time the outcome of many of the political events Europe is facing will be known. However, it looks likely that more will come along to take their place.