For years, portfolio strategists have been assessing the political risk of investing in emerging markets and assigning it a premium. But that’s not where the epicentre of political risk lies today, says Philip Chandler, a multiasset portfolio manager at Schroders.
Instead, political risk is to be found elsewhere — as Brexit, various European elections and the U.S. presidential campaign make clear. For Chandler, these are acute manifestations of a chronic problem in developed countries — and they grab attention when they flare up.
“We have significant disparity of income, wealth or employment prospects in many countries, and that’s only going to get worse as automation grows. We’ve also gone through a period of very low growth, which has been a catalyst for these disparities to become a political problem,” he explains.
“Due to demographics, low productivity and leverage in the economy, this low-growth world is going to continue. So we have this chronic problem underlying developed market economies, but we only notice it when it becomes an acute problem — when we have Brexit or elections in the U.S. and France.”
Because this new phenomenon of political risk driven by populism is so hard to analyze, Chandler argues that asset managers need a new structure for thinking about risk and a tool kit for analyzing it.
“The problem is, how do we build a tool kit for this set of political risks so that we don’t just bounce from one set of media headlines to the next?” he says.
Beyond Game Theory
Modelling political risk is difficult. In the past, analysts used game theory, which worked very well during the Cold War and can help illuminate a two-player situation like U.K.European negotiations in the Brexit process. But, Chandler says, “you can’t do game theory on 60 million people who are about to vote; you can’t do game theory on populism.”
One pitfall, which one manager did, is to enumerate all the ways things could go wrong. “You have this big list of things and you become paralyzed because there are so many things on the list,” he argues. What’s crucial is to break it into manageable components that group phenomena with common denominators.
This leads to Chandler’s recommended approach to political risk: scenario modelling. “Scenario modelling is particularly useful for political risk,” claims Chandler. “When events are uncertain, it can be hard to determine whether we should adjust portfolios or not, but by spending time thinking through the adverse effects of different scenarios, it encourages you to look for hedges.”
Finally, Chandler admits that he “hasn’t been able to find a silver bullet.” Because political risks send out global shock waves, diversification is of little avail. Put options are too expensive for long-term chronic problems, as they must be rolled for significant periods. And, even if global macro managers had better track records, their weight in most portfolios would be too small to make a meaningful difference, Chandler explains.