Can You Manage Political Risk?

Coverage of the 2017 Risk Management Conference

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weather vaneAccording to a 2017 survey of insurance asset managers, 25% of respondents named political risk as the number one risk to their portfolios today – and half ranked it among their top three worries.

That’s a huge turnaround for a group that didn’t even have political risk on their radar screen two years ago, says Stephanie Kelly, political economist with Standard Life Investments. It’s a challenge, she says, but it can be managed: “Political risk is not insurmountable – it’s very hard to predict, but it doesn’t mean we don’t have options.”

The steep climb of politics up the list of investor concerns has been driven by a couple of factors – increased fragmentation and polarization along with the growing inability of traditional polling to accurately capture public sentiment on key issues and ideas.

In other words, polling uncertainty prevails at a time when investors need polls most.

Populism is in part to blame she says: “Since the early 2000s, we’ve seen support for populist parties double. This has contributed to the fragmentation of politics.” In short, it means more parties competing in elections and greater di culty for parties to gain a majority government, making it harder to govern and pass policy.

Investors don’t like uncertainty: markets in the U.K. and Europe have fallen in the range of 25% in reaction to political shocks such as Brexit in 2016.

The big question – how do you manage political uncertainty? Seems like an impossible task – but in fact it’s doable, says Kelly: “You can ignore political risk – but as investors we need to pay attention and understand the risks inherent in ignoring it, especially in the developed world,” she explains.

Kelly advocates using a political risk framework that lets you assess the data you have and test tail risk based on it. That means thinking about the topic in two ways: institutional risk, which refers to the political foundations in a specific country, and cyclical risk, which can be election specific and capture the rise of populist movements, like Donald Trump’s election win.

Some of these risks are predictable – other scenarios can be captured and analyzed.

stephanie-kelly-chart

Take the recent election in France, for example, where Marine Le Pen ran on a populist, anti-EU platform. The polls in that case were accurate – she didn’t win. But you didn’t have to rely on polls alone. Another way to assess risk of a Le Pen win to the EU was to look at France’s hybrid political system, with both a president and parliament. “This makes it harder for France to leave the EU, and understanding this can help investors assess the likelihood that the French election could have impacted the region,” Kelly says.

“Effective political risk event analysis requires a systematic approach,” Kelly concludes – something that comes not just from polls but from other known factors like electoral systems, existing policy and other factors that provide the groundwork for political change.

Put it all together, she says, and you have a good case for understanding the link between tail risk and today’s changing political climate.

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