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Roundtable: Managing political & event risk. Part 3

Leading industry figures Wayne Bowers, Philip Chandler, CFA, Eoin Murray, Thomas Schäubli, and Jason Voss, CFA discuss the challenges that investment professionals face when managing political and event risks, and look at some of the implications of recent political developments.

In this roundtable, originally published in CFA UK’s magazine Professional Investor (PI), we continue the discussion on the subject of political risk. You can read the first and second parts here

PI: Is political risk already priced into the market?

Philip Chandler: Partially. Measures of general political risk like sovereign credit default swap spreads are wider and when political events hit the headlines then markets are quick to react (although they don’t always get it right!) but the political establishment doesn’t seem to fully understand the frustration of those left behind by globalisation and unequal wealth distribution and democracies often find it hard to make tough decisions – that’s an unstable combination which the uncertain timescales involved make it very hard to price.

Wayne Bowers: With any potential risk it is always difficult to assess if this has been under priced, fairly priced or over priced into various asset classes and market valuations. In recent years, we have seen a more cautious approach adopted by both asset owners and asset managers regarding significant potential risks being priced in. Examples include Chinese leadership change, Brexit and most recently the US Presidential elections, with lower risk profiles being implemented ahead of events and unwound either closer to an “event” or post result. This means that it is easy to suggest that political risk is priced in, but difficult to suggest if the level is appropriate per region, sector or asset class.

Thomas Schäubli: Seriously, that would be great to know! We were scratching our heads over recent developments with the pound after the British Prime Minister made clear the country was steering towards a “hard Brexit“. But wasn’t that clear all along? Perhaps the Swiss perspective allowed us to understand that there is no “soft Brexit”. For us, the continuing depreciation of the pound was thus an exaggeration. But isn’t that always the same challenge? Sometimes we identify a misjudgement by the market and derive a profitable investment idea from it. Sometimes we are equally excited but obviously wrong. If we always knew what’s already priced into the market and what’s not, we would be one happy company.

Eoin Murray: Some political risk will be priced into the market, but not always accurately, in the sense that it is frequently “tail risk”, representing events that might have an extreme outcome but low probability according to standard distributions, and hence may not be properly reflected in asset prices. Equally as with any other form of risk, from time-to-time political risk will be insufficiently priced into the market and equally at times overly priced in.

Jason Voss: In my experience, political risk is hardly ever priced by investors. I say this because over the years of talking with my investment peers about their portfolios they never mention political risk. Usually they are concerned about the stories underlying individual securities, portfolio construction, and economic growth. As I mentioned above, I think that an understanding of geopolitics is actually an untapped source of return, not just about risk management.