Do politics really matter in investments? Aren’t the political risks already factored into the market long before the risks play out? Well, historically, on average, and according to every econ 101 class, politics are known to generally only result in short- to medium-term turbulence. It is long-term, fundamental data of the economy and corporations that govern the financial markets. However, …

…if international politics and geo-political trends impact companies at the micro level, then politics suddenly do matter, and they matter a lot.

On this basis, the British banking group, Schroders, warned that investors should expect significant challenges ahead due to an increasingly uncertain geo-political landscape. The chart they used is displayed below.

Political risks at above-average levels

Source: GPR/Schroders

How uncertainty impacts economies

Geopolitical risk creates uncertainty. This weighs on economies and financial markets as decision-makers hold off from making major commitments.

Firms delay investment decisions or new hires. Consumers delay spending on big-ticket items such as cars or houses. Financial investors delay their decisions as they try to assess the economic or political impact.

The creators of the GPR – Fed economists Caldara and Iacoviello – found that significant increases in the index result in weaker economic activity and lower equity market returns. Industrial production, employment and trade are all hit, with the adverse effect persisting for a year after the initial shock.

How does it affect markets?

Geopolitical risks trigger increased risk aversion among investors. They negatively impact stock market returns in all advanced economies, whilst two-year US Treasury yields decline.

Capital flows were found to be affected too, with lower flows to emerging markets, but higher flows to developed markets.

Consistent with the downturn in economic activity, the oil price was found to weaken in response to increased geopolitical risk.

The analysis found that economic activity and financial markets were more affected by geopolitical threats than by actual events (such as the start of wars or imposition of sanctions). Threats tend to increase uncertainty and downside risks, while actual events tend to resolve uncertainty and prompt protective policy responses.

This finding reinforces the stock market adage to “buy the rumor, sell the fact”.

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