Many political developments have little impact on the financial markets. A prime example is the UK’s decision to leave the European Union in June 2016. Despite great fears prior to the referendum, the stock exchanges ultimately only reacted to the vote temporarily.
However some political developments do have a longer-term impact on the financial markets. These include the current disputes between China and the USA. The expectations of investors that the two nations will reach agreement has been reflected in equity prices in recent months. Economic data and the central banks have also clearly played a role. The fall in equity market prices in the final quarter of 2018 was also due to the tariffs introduced as well as those threatened. The easing of tensions between the two sides at the end of the year underpinned the strong recovery on the stock exchanges. Yet the recently renewed escalation in the dispute has caused stock market turbulence.
Dealing with political risks
It is not worth reacting to every political development. But in the current climate of a weakening economy and high valuations of financial investments, it is advisable to reduce risks.
Political developments are difficult to predict
The challenge for investors is that while specific political events can have repercussions, it is extremely difficult to predict how situations will unfold and what their impact will be. Economic growth forecasts are much more complex than is often suggested. However some light can be shed on the coming quarters based on the intentions of a wide range of companies and people. Meanwhile, political developments often depend on specific decisions or even individuals. A good example of this is the current US government. Predicting Donald Trump’s next tweets is clearly not easy.
Caution is advised
How should investors proceed amid this uncertainty? In our view, it is worth bearing at least two points in mind. Firstly, we advise caution. A lot of political news is just background noise without any particular relevance to the financial markets. But even if the markets react to an event, getting the timing right is very difficult. Secondly, the overall climate must be taken into account to evaluate the situation properly. It is particularly important to weigh up the mood of economies and financial markets and how sensitively they react to bad news.
The current situation justifies risk reduction
These considerations are especially valid in the current situation. There seem to be plenty of events with the potential to cause uncertainty at the moment. A look at the past suggests this has often been the case – and was rarely great cause for concern on its own. As prices have risen sharply over recent months and valuations are high, there is now significant downside potential. The economic situation is no longer stable enough for negative developments to be easily weathered. It is worth further reducing risk in the portfolio slightly in times such as these. That is what we are doing.