Schroders: Political risks and market rewards in 2016

Speaking at the Schroders Investment Conference in Budapest in September, Daniel Franklin, Executive Editor of The Economist, revealed what he thinks could be the main political risks for investors to consider in 2016…..

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Daniel Franklin, Executive Editor, The Economist

Franklin, who edits The Economist’s annual outlook publication, “The World in …”, thinks investors routinely underestimate political risks and their economic impacts.

“We talk about volatility in economics and in markets, but we should expect the same in politics,” Franklin said.

Political drivers in 2015

He highlighted the Greek crisis, the Ukraine conflict, the migration crisis, the rise of ISIS and the Chinese stockmarket turbulence as examples of significant economic events of 2015 which were arguably largely driven by political factors.

In the case of the Greek crisis, it had an economic background, but what changed in 2015 was a political development: the election of a radical, alternative government which led to six months of drama surrounding the country. The Ukraine crisis too, which had huge economic ramifications, was according to Franklin, politically driven by Russian President Putin and his reaction to policy decisions in Western Europe.

“Even the Chinese stockmarket crash I would argue had political reasons behind it,” he said. “It was caused by the government trying to change the direction of the economy and make the currency into a more market-driven global currency.”

Clearly not all political change is negative, however, and Franklin highlighted the election of Narendra Modi in India in 2014. “It changed the mood in India and brought hope that the dynamics of the country will change”.

Drivers of political change in the near-term future

Franklin named five factors likely to drive the next major political developments.

1. Anger. Specifically, the fallout from the aftermath of the deep recession. “Anger about inequality, disaffection with politics and authority. This anger will find outlets,” he warned.

2. Demographic changes. “Deep structural, fundamental changes which are helping to push some of the trends we see.” He mentioned the growth in population in the Middle East, and the resulting young population which he saw as a major driver of the Arab Spring. “There is a similar trend in Africa, where the population will double in the next 30 years,” he said.

3. The fallout from the Arab Spring. The events in the Middle East, such as those in Syria, have further to run and have far-reaching and multi-faceted effects.

4. Technology. Technology is moving fast and disrupting jobs.

5. Emerging markets. As economies adjust and drivers of growth change, this will bring about troubles and opportunities.

“All five of these are fundamental drivers of deep change that in the next year and beyond will cause some political shocks”, Franklin said.

Potential shocks for 2016

– UK referendum

“It is clear this is a big event, not just for Britain, but for the EU,” he said. Although he expects the UK to vote to remain within the EU, he thinks it will be a “dramatic process, with times when polls will suggest it will be very close”. The more difficulties the EU has in the year ahead, the more likely “Brexit” will become.

The very concept of Brexit is hugely disturbing to the EU, according to Franklin.  “The idea that one of the major members might pull out is fundamentally upsetting to the notion that the EU is a march of progress; marching continually forward to ever closer union.”

– Eurozone

“The eurozone crisis is far from over”, Franklin said, pointing out that his colleagues at the Economist Intelligence Unit still put a 60% probability on a “Grexit” over the next five years.

In addition, the current migration crisis is putting in doubt what he sees as “one of the greatest achievements of the EU”; namely, the internal free movement of people as he sees “borders going up all over Europe”. He warns that the very future of the EU could be in doubt. If political developments continue to go against the Union, we could “potentially see it unravelling in front of our eyes”.

– Ukraine

“It’s possible that the worst is behind us, but the risk is that there could be more confrontation and provocation ahead,” Franklin said, warning that other Baltic states could also become embroiled.

– US election

The US election always has a huge impact on the rest of the world, and this time around Donald Trump has been the surprise package. “Dismissed as something of a joke when he first threw his hat in the ring, he is now the frontrunner and taken very seriously indeed,” Franklin said. “I think it’s vanishingly unlikely that he will become President, but he is shaking things up in a big way.”

He thinks Trump’s rise (similar to Jeremy Corbyn’s in the UK) reflects the “anger” aspect mentioned above. “There is anger that politics as usual is not working in the interest of ordinary folk. Trump is shaking things up with a more populist style of politics which other candidates are finding they also have to adopt.”

– Terrorism

“This is something that cannot be ignored as a risk”, he said. “There could be more terrorist attacks, particularly with developments we are seeing in Syria and related to ISIS. If there is an increase in terrorist attacks which start to impact the movement of people and commerce, it could have a destabilising effect.”

– China

“We have already seen tensions between China and its neighbours in the South China Sea. If China is struggling economically one tactic they can use is to drum up support through use of nationalist rhetoric, particularly through anti-Japanese rhetoric and posturing in its own neighbourhood. It hasn’t bubbled over into anything terribly dangerous thus far, but it is a risk to look out for.”

– Overregulation

Tied to the anger at the fallout from the recession, there is a danger that regulators tie industries’ hands behind their backs too much. For example, shooing banks away from certain areas could lead to a crisis of liquidity.  Also, there has been a backlash against technological changes – specifically the hugely disruptive influence of the so-called “sharing economy” and regulatory changes that could hit the likes of Uber and Google.

What are the opportunities?

Ethical consumerism. “If it is true that there is deep dissatisfaction with business and inequality, I think you may well see a growing interest in companies that can be seen to have the magical combination of making money in a way that is seen to be ethically sound,” Franklin said.

“Or, look at it the other way: that companies making money in a way that is seen to be ethically unsound may be punished.  This will be an increasingly powerful force, particularly among younger consumers and the millennial generation.”

Demographic trends. The changes in population, in Middle East and Africa in particular, will provide opportunities. Even the migration crisis, he thinks, will lead to increased investment in those countries people are leaving. “They will want to make it more likely that people will stay and find opportunities and build futures in their homelands rather than moving to Europe,” he said.

Sectors. At a sector level, Franklin thinks the opportunities caused by political risks will be found in currencies, security and defence.


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