Lambert here: “It is a positive finding that the risk associated with broad political changes can be quantified with a globally priced factor. ” Until it can’t?
“How important is political risk for investors and policy makers?” [Stavros Zenios, Bruegel ((CC BY-ND 4.0)].
Political risk has roughly doubled in importance as a driver of global financial markets since the early 2000s. Warnings of a rupture in the global order are being taken seriously by investors, who are attempting to mitigate their exposure.
Political risk is classically understood as discontinuities in the business environment that are difficult to anticipate and result from political decisions and events. Snap elections, trade wars and coercive foreign policy are thus examples of political-risk drivers.
Our recent research shows that political risk is not a country-level phenomenon that washes out in a diversified portfolio; it is priced jointly into international stocks, bonds and currencies. Investing in countries based on political risk reveals consistent differences in returns: a 6% spread for equities, 4% for bonds and 4.5% for currencies. Our model, combining market risk and political risk, explains about three-quarters of these differences in returns across asset classes.
If international diversification of assets cannot reliably shield investors from political risk, the best strategy available to governments and companies is to manage it. Sovereign borrowing costs reflect this: a ten-point deterioration in a country’s 100-point political-risk rating scale widens bond yields by 106 basis points. For European governments weighing defence and climate spending in a tight fiscal space, that is no rounding error – it can significantly impact debt sustainability. The European Commission and national debt-management offices should embed political risk into forward-looking debt-sustainability analysis, adopting multiple ratings for a comprehensive assessment of political risk.
It is a positive finding that the risk associated with broad political changes can be quantified with a globally priced factor. But, because political risk is systematic across countries and asset classes, managing rather than avoiding it should be the goal.
Read the Analysis, ‘The growing impact of political risk on financial markets’, by Vito D. Gala, Giovanni Pagliardi, Ivan Shaliastovich and Stavros Zenios