How to Trade the Impact of Politics on Global Financial Markets

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ANALYZING GEOPOLITICAL RISKS

As 2019 continues to unfold, political risks are growing increasingly relevant to watch as their capacity for inducing market-wide volatility is significantly expanding. Globally, liberal-oriented ideologies – that is, those favoring free trade and integrated capital markets – are being undermined by nationalist and populist movements. The result – though not always – is violent volatility stemming from uncertainty.

Against the backdrop of a slowing global economy and central banks pausing or reversing their rate-hike cycles, the introduction of additional uncertainty will likely create even more volatility. What makes political risk so dangerous and elusive is the limited ability investors have for pricing it in. Traders may therefore find themselves hot under the collar as the global political landscape continues to unpredictably shift.

Generally speaking, markets do not really care about political categorizations but are more concerned with the economic policies embedded in the agenda of whoever holds the reigns of the sovereign. Policies that stimulate economic growth typically acts as a magnet for investors looking to park capital where it will garner the highest yield.

These include the implementation of fiscal stimulus plans, fortifying property rights, allowing for goods and capital to flow freely and dissolving growth-sapping regulations. If these policies create adequate inflationary pressure, it could prompt the central bank to raise interest rates as a response and lead to a stronger exchange rate for the country concerned.

Conversely, if you have a government whose underlying ideological predilections go against the gradient of globalization, this may cause capital flight. Regimes that seek to rip out the threads that have sown economic and political integration usually create a moat of uncertainty that investors do not want to traverse. Themes of ultra-nationalism, protectionism and populism have frequently shown to have market-disrupting effects.

If a state undergoes an ideological realignment,traders will assess the situation to see if it radically alters their risk-reward set up. If so, investors may then reallocate their capital and re-formulate their trading strategies that tilt the balance of risk to reward in their favor. However, in doing so, volatility will likely follow as the reformulated trading strategy is reflected in the market-wide redistribution of capital across various assets.

EUROPE: EUROSCEPTIC POPULISM IN ITALY

In Italy, the 2018 election roiled regional markets and eventually rippled almost throughout the entire financial system. The ascendancy of the anti-establishment right-wing Lega Nord and ideologically-ambivalent 5 Star Movement was founded on a campaign of populism with a built-in rejection of the status quo. The uncertainty accompanying this new regime was then promptly priced in and resulted in significantly volatility.

The risk premium for holding Italy’s assets rose and was reflected in an over one-hundred percent spike in Italian 10-year bond yields due to investors demanding a higher return for tolerating what they perceived to be a higher level of risk. This was also reflected in the dramatic widening of the spread on credit default swaps on Italian sovereign debt due to increased fears that Italy could be the next epicenter of another EU debt crisis.

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