Political Wildcards

Investors tend to focus on the factors they’re most familiar with when looking at markets. Analyzing items such as corporate earnings and economic indicators take center stage.

The past year, however, was a vivid demonstration that a much more difficult to model and unpredictable force—political risk—can overshadow typical market events. And based on the political trajectory of the past year, political and geopolitical risks are likely to be even more central to market movements in 2018. Knowing which geopolitical risks to monitor along with the usual items, such as earnings and economics will be key for investors in the year ahead.

The wildcard candidacy and 2016 presidential election of Donald Trump was central to the market dynamics in 2017. Trump’s candidacy was initially mocked, to the point where The Huffington Post initially refused to cover him in its politics section, relegating coverage to its humor section.

Trump’s longshot victory lay bare how poorly political scientists, polling models, and pundits were equipped to read political tea leaves. The administration’s promises of fiscal expansion and deregulation, meanwhile, were key to driving risk assets much higher over the year.

That same wildcard of political risk continues to play out in the US, in the UK with Brexit, and worldwide with the threat of nuclear confrontation.

“Politics are clearly clouding the macro trading environment. If it were not for the recent set of political surprises, the US outlook would be less dependent on Twitter alerts, the pound a lot higher, and perhaps less concern over a possible nuclear escalation,” analysts at Nomura wrote in a September research report. “The politics can really catch markets off guard. Earlier this year, the potential of an upset in the French election weighed on the euro, but that was precisely the moment when the European data picture started showing strong upsides. And, at the start of the year, the ‘Trumpflation trade’ was in full swing, but the dollar lost its stride.”

The biggest geopolitical risk, however, remains the escalation of tensions with a North Korean regime intent on flexing its nuclear muscle.

The stakes for markets would be enormous. “I think it’s impossible to put a number on the scale of the risk. But what we can say based on the extent of the war games exercises that have simulated what the impact would be going back decades, is that a conflict in the Korean peninsula would be not only very disruptive in the region, but could potentially lead to World War III because of the US security guarantee, so it would be internationalized overnight,” Citi’s Chief Global Political Analyst Tina Fordham said at the Milken Institute Asia Summit in September. “It’s very difficult to measure the duration of such a conflict or even the scope, but it is the single-biggest geopolitical threat, and one that would also move markets. This is different from, for example, the Syrian conflict, which has been extremely disruptive on a human level with the refugee crisis and everything else, but hasn’t generated an oil price spike. So, when we look at political risk, we look at, for example, is it likely to cause an oil price shock or a growth shock, and in the North Korea case, if the worst were to happen, it would be both.”

Even the most experienced analysts of political risk, meanwhile, have a tough time handicapping these kinds of tail risks. And Trump’s temperament makes the exercise even more challenging. “As someone who is a veteran of doing this, I’m pretty loathe to try and ascribe probability when there is just so much volatility in the key players,” Fordham said. “Not only is the North Korean leader ramping up the tests with six this year, but Donald Trump is also changing US foreign and security policy in a way we haven’t seen before. That mix of unpredictability in the key leaders just adds to the risk of the potential for misunderstandings and accidents at a minimum, and possibly something worse.” 

Art by Suharu Ogawa

Moreover, implications for markets range on a whole host of outcomes—not just if there is an all-out war or not. “I would also say that this isn’t just a binary kind of an outcome. Investors tend to see it as their ‘will or won’t be’ conflict, and given that conflict would be so disruptive, that’s just unlikely to happen,” Fordham said. “There are also implications in between those outcomes. For example, trade disruptions, US-China tensions, and other things that will also matter to markets if they come to bear, so that’s another way of looking at it from an investment perspective.”

The risk of nuclear proliferation amid a regional arms race and the instability it introduces could be another risk for markets.

“A policy of deterrence against North Korea would carry new concerns for proliferation, too,” analysts at the geopolitical research firm Stratfor wrote in a report in September. “Not only could South Korea and Japan seek out their own nuclear weapons, but North Korea would also set a troubling precedent for other nations: So far it is the only country to have joined the Non-Proliferation Treaty before subsequently withdrawing to pursue nuclear weapons.”

So far, investors seem to have turned a blind eye to these mounting risks. Risk assets such as stocks keep pushing to historic highs, even as volatility remains muted. But it may not be the absence of risks that is leading to market complacency. Rather, investors find it difficult to wrap their arms around risk, and, therefore, it’s easier to ignore.

As 2017 demonstrated with a once seemingly impossible Trump victory, so-called tail risks can materialize rapidly. And the groundwork being laid for 2018 should be a warning for investors to keep a sharp focus on them, even if market complacency tells another story.