Now would arguably be a good a time as ever to discuss the implications that political instability has on a country’s stock market returns and the economy.
Political instability is rife in several countries, and often can linger for a number of years. It comes in various shapes and sizes, such as Brexit, dictatorial regimes, political impasses and outright civil wars, which affects countries to varying degrees. The long and short of it is that intuitively political instability is not good for any economy, but just how grave the impact can be has been investigated across a number of empirical studies.
The difficulty in assessing the economic fallout of political instability isn’t calculating periodic changes in GDP at face value, as many of the effects are often not immediate and not easily measurable. One of the largest immeasurable consequences is the concept of opportunity cost. Opportunity cost is defined as the loss of other alternatives when one alternative is chosen.
By way of an example, if an individual or corporation, ceteris paribus, is considering different jurisdictions in order to set up a shoe factory, if a subject country is not selected due to the political situation in a country, that “missed opportunity” would not be captured by any economic metric. A quick overview of what literary studies have shown include Diamonte et al. (1996) and Lehkonen and Heimonen (2015), showing that a reduction in political risk could lead to higher portfolio and stock returns. Huang et al. (2015) find a positive relationship between international political risks and government bond yields.
Developing this point further, the practical impact is that the subject Government’s cost of funding increases due to an increase in political risk. This is congruent to a downward revision in the credit rating of a country, which raises the yields on government debt.
Smales (2014) uses the Australian federal elections as a proxy for political uncertainty. He shows evidence that the political uncertainty proxy used has a significant impact on the uncertainty of the financial markets. Li and Born (2006) and Gemmill (1992) also provide evidence of a strong relationship between the elections and the financial markets.
What the studies have shown is that investor demand is influenced by the shifts in the political climate. Moreover, these changes affect the returns of firms and industries that are politically sensitive. It results that political uncertainty commands a risk premium whose magnitude is larger in weaker economic conditions. It makes stocks more volatile and more correlated, especially when the economy is weak.
In my opinion, a difference needs to be made between political instability as a result of legislative volatility and personality/political party. The main concern from an equity perspective is to have legislative stability, whereby a company conducting business can operate in a known environment that it chooses to engage in. In this respect, the European Union for example provides a base for legislative stability, due to the harmonisation of many laws across the union.
The personality or political party is of lesser importance, in the sense that as long as the agenda of the political party is commensurate with legislative stability, the equity market is set to thrive no matter what.
Taking an example from the US, after Barack Obama’s elections markets started to plunge, not due to investors’ fear of Obama’s policies, but due to the financial crisis. However, as the markets started to recover from 2009 with a bull run that has not yet ended, any political argument was no longer valid. Obama’s election coincided with the financial crisis and investors’ heavy selling was nothing to do with his policies.
To summarise, investors have to distinguish the real impact of political developments or new policies on the stock market from other macro factors affecting the economy. It is only one input into the consideration when forming opinions about the stock market, albeit an important one.
Disclaimer: This article was issued by Simon Psaila, capital markets and research manger at Calamatta Cuschieri. For more information visit www.cc.com.mt. The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.