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What does political risk premium mean for traders and investors and where to own equities: Europe, US or China?

Ashwani Mathur

Ashwani Mathur Hedge Fund Broker & Trading Educator.

For those of you who started their careers in Emerging Markets in the 1990s, the concept of a “political risk premium” is nothing alien. We were all indoctrinated with this. Wherever you invested, whether it was in Suharto’s Indonesia, Mahatir’s Malaysia, a Nuclear-assertive India, a Junta-dominated Pakistan or a Kleptocratic Russia—the dictum was the same. Investing often meant taking the Politically Imperative Supine Subplots (no pun intended). Along with WACC you applied some sort of a political discount to valuation before you stepped in to buy EM equities. You made bets with your eyes wide open. It made sense back then and it continues to make sense today. Why else would those markets still be called “Emerging Markets” otherwise? The bigger question we now face is this : Shouldn’t one start to price in a political risk premium for US and European equities from here? Has American politics become more stable or unstable? Has the UK post-Brexit become a safer place to invest? What about France? The leading party into the next election is ahead because of its anti-Islamist agenda. And Trump won his election on pretty much one platform. Isn’t there a case to be made now that in coming quarters developed markets will take a political leaf from the 1990s EM playbook?

Sounds like blasphemy doesn’t it. Are we seriously suggesting that investors should start building in a political risk premium into valuations of US and EU stocks? We absolutely are. The world has changed in the last few months. Gone is the dominance of the Central banks in driving asset prices. It is now universally acknowledged that the QE experiment was a success in the eyes of its proponents. If indeed that were true, we would not be as polarised as we are. CB-driven asset prices should now be a thing of the past. The Fed has been behind the curve and the ECB has little credibility. So what is going to drive markets from here? The answer lies in politics. Now we are getting way out of our pay grade to talk about the impact of politics on asset markets, but we raise this question. Never has the developed world been caught in so much strife internally in every country than it is currently. The UK & US are divided and if Italy and France go the way they are threatening to go, will global markets survive a sharp downturn coming from European equities next? Yes, the US equity indices are breaking to new highs but there is simply no confirmation from Europe.

The answers lie in price action

There is only one way to empirically study the mind of the market. And that is through price action. Because price action is the only thing that tells you what the equilibrium level of the market is. Where buyers and sellers settle through a clearing price. Price may not always not tell you what the future holds, but it tells you what the current state of play is and where the trend has been. You then apply conditions based on your own expectations to either extrapolate the trend or turn contrarian.

On the left is the chart of Eurostoxx relative to the SPX. You can see that it is making new relative lows today and has been in a sustained downtrend from 2007. Owning European equities for global investors has been a complete waste of time and capital on a durable basis. 9 years on and it still manages to make new lows. Now study the European political backdrop. Do you really believe that this trend is about to turn up or is the probability higher for this trend to accelerate to the downside? Now look at the other chart. Chinese equities are breaking higher against Eurostoxx. Makes sense. China is politically far more stable today than Europe. Price action confirms.

Source Data: Bloomberg, Company Accounts, Third Party Industry Research. Author: Ashwani Mathur

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