How to Trade the Impact of Politics on Global Financial Markets

ANALYZING GEOPOLITICAL RISKS

Against the backdrop of eroding fundamentals, markets become increasingly sensitive to political risks as their capacity for inducing market-wide volatility is amplified. When liberal-oriented ideologies – that is, those favoring free trade and integrated capital markets – are being assaulted on a global scale by nationalist and populist movements, uncertainty-driven volatility is the frequent result.

What makes political risk so dangerous and elusive is the limited ability investors have for pricing it in. Traders may therefore find themselves hot under the collar as the global political landscape continues to develop unpredictably. Furthermore, much like the spread of the coronavirus in 2020, political pathogens can have a similar contagion effect.

Generally speaking, markets do not really care about political categorizations but are more concerned with the economic policies embedded in the agenda of whoever holds the reigns of the sovereign. Policies that stimulate economic growth typically act as a magnet for investors looking to park capital where it will garner the highest yield.

These include the implementation of fiscal stimulus plans, fortifying property rights, allowing for goods and capital to flow freely and dissolving growth-sapping regulations. If these policies create adequate inflationary pressure, the central bank may raise interest rates in response. That boosts the underlying return on local assets, reeling in investors and lifting the currency.

Conversely, a government whose underlying ideological predilections go against the gradient of globalization may cause capital flight. Regimes that seek to rip out the threads that have sown economic and political integration usually create a moat of uncertainty that investors do not want to traverse. Themes of ultra-nationalism, protectionism and populism have been frequently shown to have market-disrupting effects.

If a state undergoes an ideological realignment,traders will assess the situation to see if it radically alters their risk-reward set up. If so, they may then reallocate their capital and re-formulate their trading strategies to tilt the balance of risk to reward in their favor. Volatility is stoked in doing so however as reformulated trading strategies are reflected in the market-wide redistribution of capital across various assets.

EUROPE: EUROSCEPTIC POPULISM IN ITALY

In Italy, the 2018 election roiled regional markets and eventually rippled through virtually the entire financial system. The ascendancy of the anti-establishment right-wing Lega Nord and ideologically-ambivalent 5 Star Movement was founded on a campaign of populism with a built-in rejection of the status quo. The uncertainty accompanying this new regime was then promptly priced in and resulted in significantly volatility.

The risk premium for holding Italys assets rose and was reflected in an over-100 percent spike in Italian 10-year bond yields. That showed investors demanding a higher return for tolerating what they perceived to be a higher level of risk. This was also reflected in the dramatic widening of the spread on credit default swaps on Italian sovereign debt amid increased fears that Italy could be the epicenter of another EU debt crisis.

The US Dollar, Japanese Yen and Swiss Franc all gained at the expense of the Euro as investors redirected their capital to anti-risk assets. The Euro‘s suffering was prolonged by a dispute between Rome and Brussels over the former’s budgetary ambitions. The governments fiscal exceptionalism was a feature of their anti-establishment nature that in turn introduced greater uncertainty and was then reflected in a weaker Euro.

LATIN AMERICA: NATIONALIST-POPULISM IN BRAZIL

While President Jair Bolsonaro is generally characterized as a fire-brand nationalist with populist underpinnings, the market reaction to his ascendency was met with open arms by investors. His appointment of Paulo Guedes – a University of Chicago-trained economist with a penchant for privatization and regulatory restructuring – boosted sentiment and investors confidence in Brazilian assets.

From June 2018 to the Covid-19 global markets rout in early 2020, the benchmark Ibovespa equity index rose over 58 percent compared with a little over 17 percent in the S&P 500 over the same time period. During the election in October, the Brazilian index rose over 12 percent in just one month as polls revealed that Bolsonaro was going to triumph over his left-wing opponent Fernando Haddad.

Since Bolsonaro‘s ascent to the presidency, the ups and downs in Brazilian markets have reflected the level of progress on his market-disrupting pension reforms. Investors speculated that these structural adjustments will be strong enough to pull Brazil’s economy away from the precipice of a recession and toward a strong growth trajectory, unburdened by unsustainable public spending.

ASIA: HINDU NATIONALISM IN INDIA

The re-election of Prime Minister Narendra Modi was broadly welcome by markets, though lingering concerns were raised about the effect of Hindu nationalism on regional stability. However, Modi has a reputation for being a business-friendly politician. His election lured investors into allocating a significant amount of capital to Indian assets.

However, investors optimistic outlook is periodically undermined by periodic clashes between India and its neighbors over territorial disputes. In the first breaths of 2019, India-Pakistan relations soured drastically amid a skirmish over the disputed Kashmir region. Since the 1947 partition, the hostility between the two nuclear powers has been an ever-present regional risk.

Tension between India and China, particularly over the disputed border known as the Line of Actual Control (LAC) in the Himalayan Mountains also rattled Asian financial markets. In June 2020, news of a skirmish between Chinese and Indian troops resulting in over 20 deaths raised concerns about what further escalation could mean for regional security and financial stability.

Nationalist campaigns and governments are embedded with political risk because the very nature of such a regime relies on displaying strength and frequently equates compromise with capitulation. In times of political volatility and economic fragility, the financial impact of a diplomatic breakdown is amplified by the fact that a resolution to a dispute will likely be prolonged due to the inherently stubborn nature of nationalist regimes.

US President Donald Trump and Modi employed a similar brand of strong rhetoric both on the campaign trail and within their respective administrations. In a rather ironic way, their ideological similarity may in fact be a force that causes a rift in diplomatic relations. Tensions between the two have escalated in 2019, with markets worrying that Washington may start another trade war in Asia, opening a second front in India having already engaged China.