Political risk returns to the financial markets

Demonstrators clash with riot police outside the Greek Parliament on June 29, 2011 in Athens during a 48-hour general strike
Image caption Displays of public anger at austerity measures in Madrid, Lisbon and Athens are a sign of growing competition between capital and labour

Political risk - ranging from intervention by politicians, to civil unrest and war - is a growing influence on investments in developed markets, and one that is likely to accelerate over the coming decade.

Although investors have historically incorporated an element of geopolitical risk assessment in emerging markets, it has been at least one and possibly two generations since they last looked seriously at the issue of political risk in the context of developed economies.

I would argue that in the history of developed markets, political risk was once the norm, but faded as an investment consideration post-World War II.

This occurred in part because the ensuing Cold War gave developed Western nations stability through a common enemy, and in part because we experienced a long period of prosperity, fuelled by a mixture of technology, reform, productivity and credit.

Protectionism and anger

It seems to me that the financial crisis is not just a minor correction in this trajectory, but the beginning of a fundamental shift in direction.

The economic damage done by the excess of the credit boom in the preceding decade and the fall-out from the financial crises have plunged the developed economies into a period of protracted anaemic economic growth, despite an unprecedented injection of stimulus.

In other words, where the world was used to an ever expanding economic "pie", we now have to contend with, at best, a static and possibly a shrinking one.

At such times, one would expect more friction as countries compete with each other for a larger share.

One would also expect more competition between labour and capital for a share of the "pie" within countries.

We have seen examples of the former in the first shoots of a protectionist mentality and trade friction between the US and China.

Examples of the latter were seen in the displays of public anger at austerity measures in Madrid, Lisbon and Athens, as well as a slow but steady rise of demand for action by the labour unions in the US and Europe.

Massive burdens

This arguably cyclical trend is taking place against a background of seismic societal changes, some of which are exacerbated by the crisis while others were in place long before the crisis made them manifest.

Among the former, is the ever increasing debt burden of developed governments, made worse by the need to borrow further at this juncture (averaging well over 80% of GDP for many).

But the debt burdens pale into insignificance if we add the implicit governmental commitments to welfare and pensions.

At which point one could argue that in many cases these obligations cannot be discharged.

Among the latter are the demographic trends of an ageing European population incapable of self-renewal at current trajectories, or of supporting its ageing population, and the potential political implications of the shift of ethnic mix in the US from an Anglo-Saxon majority country to an Anglo-Saxon minority country in less than 30 years.

Military might dwindling

Image caption Fund managers must make sure they understand the power of political movements

Meanwhile, these changes in developing countries are taking place against a background of the inexorable rise of Chinese military and economic power and profound geopolitical shifts in the Middle East in part triggered by a youth bulge.

Throughout history, there has come a tipping point for every empire when it has started to spend more on servicing its debt than on its armed forces.

In the US, it is likely this is only 10-15 years away.

What happens when a massive military country starts to lose power?

It either isolates itself, and the US has the capability to do just that, or it expands its territory.

Disenfranchised majority

Meanwhile, Europe, which is struggling with structural flaws and conflicting national interests, is fragmenting.

Tension between the countries is mounting in much the way it did in the 19th Century, which is why the political elite is so desperate to keep the euro dream alive almost at any cost.

At the same time, Western countries are already witnessing the budding sentiment among their citizens that democratic governments are ruled by a political elite and the wealthy, which disenfranchises the majority.

The upsurge of the Tea Party movement in the US and the recent showing of extreme parties in many European nations goes to highlight that in times of strife, political extremism grows.

Political change and influence may be slow to occur, but it is already being felt in many Western markets.

Just look at the politically motivated interference in the investment and corporate regulatory environments, a trend that can only increase.

Political economy

In practical terms, this means the way in which we approach investments also has to change.

Economic variables such as GDP and interest rates are becoming too shallow measures of a country's risk-reward profile.

Long-embedded financial concepts, such as mean reversion or efficient market theory, are already lessening in importance.

We are now approaching an era when one cannot make investment projections that do not take into consideration the actions of politicians as primary considerations.

The investment world needs to wake up to the fact we operate in a political economy, not a hermetically sealed financial system.

Asset managers have to start employing political analysts and become as aware of politics as they are of economics.

Investors can make money in times of discontent and political struggle - they just have to better understand the risks they may be taking.

There are opportunities to be found and there will be winners and losers in this changing world.

There is just a new set of parameters that asset managers will need to consider.

Saker Nusseibeh is chief executive and head of investment at Hermes Fund Managers.

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