Special Report, Outlook 2015: Political & Geopolitical Risk
“My whole world is falling, going crazy…. There is no escaping now, I’m crackin’ up”.
It’s not just the architectural synths and driving beats that make ABBA’s 1981 classic ‘The Visitors’ seem familiar to modern ears. Dating from when Sweden was a frontline in the Cold War, it resonates uncomfortably as warships hunt for Russian submarines in the Stockholm archipelago.
It’s 2014, and geopolitical risk is back. It’s not as if nothing happened since the Berlin Wall came down, but the sudden confluence of a US government shutdown, Russia’s annexation of Crimea, the march of Islamic State and the polling successes of anti-EU parties, not to mention the threatened break-up of the UK, has concentrated minds. Citigroup research confirms there have indeed been more frequent elections and public protests since 2011 than in the preceding decade.
Underlying the flashpoints – any one of which could lead to a lasting realignment – are long-running issues of debt sustainability and inequality. It’s no surprise that, in a highly ‘political’ year like 2014, the book that excited the most attention in our industry should be Thomas Piketty’s Capital in the Twenty-First Century, which offers both context and data on these crucial questions of political economy.
IPE readers certainly think about these issues. The KLM pension fund for ground crew in the Netherlands sold its Russian holdings this year, for example. Stefan Beiner, head of asset management and deputy CEO at Switzerland’s Publica makes the larger point that the Russia-Ukraine clash is a symptom of the “rising stars” of the emerging world jostling for position in the “global power system”, implying that one of the major investment opportunities for pension funds might also be a source of terrible instability. But his concerns also reflect the growing recognition that political risk is not confined to the emerging world. “Will politicians be able to make sure that income growth is more evenly distributed?” he asks. “Otherwise there could be social unrest, even in developed countries.”
So where is the market turmoil? The rouble, hryvnia and Russian stocks have taken a battering, but beyond local borders the conflict in Ukraine has sent mere ripples through global markets. As our lead article points out, a geopolitical event is itself necessary but not sufficient to cause geopolitical portfolio risk. There has to be a vector to transmit that risk, usually the banking or energy complex. A shooting war in Ukraine seems much more momentous than a few localised housing bubbles in the US, Ireland and Spain, but there is no doubt which has so far caused the most damage in investment portfolios.
When we pursue this idea in our discussion of gold, oil and equity volatility – surprisingly bad investments for 2014 – the conclusion is that there probably isn’t much whose price moves simply in response to events. There are fundamental reasons why gold tanks when interest rates start rising, oil swoons when the Saudis turn on the taps, and volatility disappears when there is so much central bank money in the system.
This is why, before we end on the sands of international taxation, shifting underneath your portfolio companies with popular discontent over inequality, we spend time discussing the politicisation of central banks.
Their actions in response to the 2007-08 financial crisis inevitably involved closer co-operation with government. The question of how much of their independence they will be able to claw back, and what example other policymakers will take from them, is very much open. In the more immediate future, as they gradually allow markets to set the price of the risk-free rate once again, asset prices may become more sensitive to their fundamentals – and the global risk environment.
Of course, there are other theories as to why markets have been so becalmed, such as that offered by Jean Maigrot, manager of NewSmith’s macro-inflected long/short European equity strategy.
“The fund management industry conventionally thinks that politics will sort itself out in the end,” he observes. “One thing fund managers can’t put into a spreadsheet is the impact of geopolitical tension on the profitability of a company, so they exclude it from their process altogether.”
Maigrot cites the euro as exemplifying “this tendency to assume-away political risk”. Most portfolio managers insist that a break-up “is not going to happen” as a matter of faith. “They fail to notice these things until the very last minute, and then they panic,” he observes.
But then again the euro is still with us, precisely because it is as much a political as an economic project. A few words from a central banker turned panic back to calm. That’s the other side of political risk – the uncanny ability of the people in charge, and market participants, to keep the show on the road in defiance of all rationality.
This might be the master political risk facing investors right now. ‘The Visitors’ sang of a world falling apart in 1981. What did the earworm for 2014 exhort us to do as turmoil raged across the front pages? “Clap your hands if you feel that happiness is the truth.” No wonder the VIX barely budged.