Political instability creating investment opportunities?

Does politics matter to investors? Read any market report and the answer might seem obvious. Market movements are often explained as reactions to an unfolding political story - Brexit, Catalonia, North Korea, Trump, European elections. All of these have at times over the past 18 months seemed to be key market drivers. The reality is more nuanced.

These five political stories have influenced financial markets in quite different ways from which investors can draw a range of conclusions.

Brexit is the longest-running of the five and to UK investors probably seems the most important. The distinguishing feature of this story is that, unlike some if not all the others, it is having a real economic impact. In the last week we have seen how the stalling negotiations with the rest of the EU, and the associated Westminster psychodrama, is dragging the UK economy down. A near 10pc fall in car sales in the key month of September, dismal construction sector data and a slide from the top to the bottom of the G7 growth league is starting to look like a worrying trend.

What is interesting from an investment perspective, however, is that this relentless flow of bad news has been largely shrugged off by investors. The FTSE 100 stood at around 6,000 in June 2016. Today it is close to an all-time high above 7,500. The reason, of course, is that Brexit uncertainty and a rudderless government has hit the value of the pound. And for a market dominated by exporters and overseas earners that has been a positive for sterling-based investors.

Over in Europe, politics has been influential in a quite different way. A year ago, the prospect of a packed electoral calendar across the region cast a long shadow over markets. Britain’s vote to leave the EU and the election of Donald Trump in the US seemed to point to a turning of the tide in Europe towards right-wing populism. Concern about victories for nationalist parties in Holland and France, if not in Germany, ensured that market sentiment was weak as 2017 began.

The reality was more benign. Pragmatism and common sense prevailed in all the key elections and investors have been able to focus on Europe’s rapidly improving economy, its supportive central bank and its rising corporate earnings. So in Europe the key influence of politics until recently was to unnecessarily dampen sentiment and so to create investment opportunities. Germany’s DAX index is up more than 20pc over the past year; Italy’s stock market is more than a third higher.

The market reaction to Catalonia’s bid for independence has highlighted how dramatic political events can have an outsized influence over investors. The slide in Spanish shares last week was the biggest in 15 months and outflows from Spanish funds the greatest since an earlier independence poll in 2014. Madrid’s Ibex 35 index has fallen by 10pc since a high in May, a technical market correction and completely against the tide of European markets as a whole.

Catalonia accounts for a significant proportion of the Spanish economy so the potential for disruption should not be dismissed. But given how much easier it will be for the region to declare independence than actually to deliver it, with no obvious support for secession from the international community and Madrid’s determination to block it, the market reaction may well turn out to be too much too soon. Investors appear to have over-reacted to the political drama and focused too little on the real economic impact.

Turn to North Korea and the market reaction has been just as puzzling in the opposite direction. When you consider the worst case scenario, investors’ response to Kim Jong-Un’s sabre-rattling looks complacent. Indeed the market most obviously at risk from an escalation of the Kim/Trump stand-off has seemingly welcomed the crisis. The Kospi index in Seoul stands 20pc higher than a year ago and it has been  positively correlated to the intensification of Kim’s nuclear rhetoric. The more missiles he has fired, the higher the Kospi has risen.

Actually this makes more sense than might appear. Again it is about probabilities. The market has taken the view, probably rightly, that a nuclear conflagration is unlikely. More likely is that this turns out to be a storm in a teacup. The crisis will pass and South Korea will be seen again as one of the biggest beneficiaries of the ongoing uptick in global economic activity.

Which leaves Trump, and specifically his proposed tax reforms. From a market perspective, this has been the most important political influence in recent weeks, driving Wall Street to a record-breaking run of new record highs. Like the Catalonia situation, this looks to be an over-reaction, this time a positive one.

The market has latched onto the White House’s tax reform proposals, seeing them as the key to re-starting the stalled Trump Trade that galvanized Wall Street in the wake of the Presidential election last year. In doing so it seems to have fallen into the trap of wishful thinking. Hoping that something will happen is a poor substitute for a careful analysis of whether it is likely to. Rather, this looks like an ex-post rationalisation of a late-cycle market rally. Shares are going up; how can we explain this?

So the short answer to my opening question is that politics does matter to investors but in unpredictable and often contradictory ways. Investors over- and under-react to political developments. The economic impact is more important than the political headline but this is often hard to fathom at the time and may change subsequently (as with the fading of the post-Brexit honeymoon period). 

What is clear, however, is that for the alert investor politically-driven sentiment shifts can create great investment opportunities.