Are markets too complacent about political risk?

Financial markets appear to have become unusually sanguine about risk, writes Jason Hollands, managing director at Tilney Bestinvest. 

After the relaxing Easter break, there is lots happening on the newsflow front that could move markets with the standoff between the US and North Korea, elections (more below) and we are also entering the first busy week of the US reporting season (I am reliably told that no fewer than 46 S&P 500 companies are due to report over the week).

Politics is set to continue to loom large in investors’ minds following Theresa May’s announcement today of a snap General Election on 8 June to seek a new mandate to get on with the task of delivering ‘Brexit’. 

Sterling spike 

The announcement, coming after a spate of opinion polls indicated a sizeable 20-point lead for the Conservatives, has been greeted with an immediate spike in sterling because of the likelihood of the Government achieving a bigger working majority in parliament. 

That should both strengthen its hand in the negotiations with the EU and, perhaps more importantly, also make it less of hostage to the demands of both hard-line Brexiteers on the Tory backbenches and ardent Remainers who might hope to block Brexit altogether. 

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Currency markets move quickly to cast their vote on such news events and while the rally in the pound will be taken as a signal of trader approval for the news, a sustained stronger pound might reduce some of the positive impact on large UK listed companies which earn most of their revenues overseas but report their profits in sterling. A sustained lifting of sterling off its nadir will also see a partial reversal of some of the stellar gains UK investors have enjoyed from their overseas holdings over the last year. 

One of the biggest risks facing investors who have notably shunned UK markets in favour of  international funds over the last year – and especially those who have piled into the US on the back of the Trump victory – is a recovery in sterling should the UK economy continue to perform well and negotiations with the EU prove more constructive than many fear.

France provides the next big poilitical test

More immediately, however, it is France that provides the next big political test and a source of anxiety for investors, with the first round of its Presidential elections this Sunday. Since the start of the year attention has focused principally on the prospect of controversial nationalist Marine Le Pen topping the first round but ultimately being defeated in the second round by either centrist, ex-Rothschild banker Emanuel Macron, or (less likely) ‘Thatcherite’ Republican Francois Fillon. 

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But in recent days a surge in support for Communist backed Jean-Luc Melenchon has blown the contest wide open, with a very tight race between four candidates, each hovering around the 20 per cent mark in the polls with a range of 4 points between them. This has raised the very market-unfriendly scenario of Le Pen and Melenchon making it through to the second round. 

Both these candidates from two extremes of French politics are hostile to the euro and such an outcome has the potential to provoke an eruption of volatility in European markets next week. But should at least one of the more mainstream candidates make it through, most likely Macron, there could be a relief rally.

Calm before the storm?

That said, markets appear to have become unusually sanguine about risk, with incredibly low levels of volatility so far this year despite the challenges faced by the UK in negotiating its EU exit, the election of property mogul Donald Trump as US President, tensions with Russia over Syria and sabre rattling between North Korea and the US administration that could trigger war on the Korean peninsula. 

With many developed market indices trading at record levels and both equities and bonds looking expensive on a number of measures, very low levels of volatility looks like a sign of worrying complacency – could this be the calm before the storm? 

Reasons to remain positive 

There are certainly reasons to remain positive, with outlook for global growth improving and inflation finally on the rise as the baton gets passed from central banks of have spent years trying to stoke it through ultra-loose monetary policy to governments pledging to implement fiscal stimulus measures. And on a more intuitive measure, while fund flows by retail investors have been improving, there aren’t yet the signs of a care-free stampede into the stock markets that historically has often accompanied the latter stages of previous bull markets.  

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In truth trying to second guess when markets have peaked is a mug’s game and the good times could roll on for some time yet. But with volatility eerily low, valuations high and the current bull market long in the tooth, these are certainly times to be especially aware of potential downside risks and to act with a degree of caution. For those contemplating new long-term investments, a really sensible approach is to drip feed cash into the markets over several months rather than piling in aggressively. The time for heroics is when markets are plummeting and others are panic selling, not when indices are scaling new heights.

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