For many years, political risk was considered the preserve of emerging markets, often characterised by extremism, populism, military coups, irresponsible government spending and currency collapses. 
However, since the financial crisis, political risk has been on the rise in developed countries. This is important for financial markets because these countries tend to have bigger economies and larger stock markets.
The charge that economic stagnation is behind this rise in political risk is only partly true.
The more subtle reality is that inequality within countries has worsened, often hitting the younger demographic hardest. This, combined with a political establishment that has been struggling to offer solutions, and in some cases has been embroiled in corruption scandals, has seen disenfranchisement rise, especially in this more typically radical population group.
As a result, the political spectrum has fragmented, with traditional parties losing ground and newer, anti-establishment parties, or more radical elements within traditional parties, coming to the fore.
In fact, the growth of broad political movements such as Occupy and Los Indignados in Spain has also been a characteristic, facilitated by the growth of social media and a preference to organise outside the traditional political structure.
Often this has meant the political strength of parties in power, or coalitions, has been weakened, ironically at a time when policy action needs to be more aggressive. Meanwhile, the almost dogmatic preference for austerity has also removed one of the traditional levers of government.
This has meant that central banks have been left to do much more of the ‘heavy lifting’. Traditionally more focused on keeping the lid on inflation, a lack of growth and the threat of deflation has seen much broader mandates for central banks, with the use of much more unconventional tools.
There is an understandable perception that these unelected central banks wield too much power, adding to the sense of voter disenfranchisement. Adding to this feeling, quantitative easing, through driving up asset prices, has benefited those with assets, arguably contributing to levels of inequality.
Alongside these developments in more mature economies, the nature of political risk in emerging markets has changed.
Performance of index over 5yrs
Source: FE Analytics
More recently, the collapse in commodity prices has added pressure to those emerging markets that are commodity producers, while the growth of social media and a burgeoning middle class has contributed to a more empowered and vocal electorate.
So, trust in politicians and in political institutions has fallen globally, often expressed in an anti-establishment voice.
For example, the build up to the US election has seen massive support for the left-wing radical Bernie Saunders and the right-wing populist Donald Trump, both anti-establishment figures. Meanwhile, Brazil has seen its president suspended, awaiting an impeachment trial, while Turkey has recently faced a military coup and a subsequent purging of alleged supporters of the coup.
So what does all this mean for markets?
Political outcomes are notoriously difficult to predict and, while polls or bookies’ odds are closely followed, they are often not very accurate. As a result, markets find it very difficult to price political risk.
Paradoxically perhaps, the very same unconventional monetary policy which has contributed to higher political risk through higher inequality, has also dampened the actual impact of political risk on markets, as it has dampened the impact of risks generally.
In the case of an election or referendum, a single day binary event is not something we would consider as an investment opportunity, rather an exercise in managing risk. We might expect elevated volatility and try to minimise that but we would position ourselves as outcome-neutral, as we did in the recent EU referendum.
Going forward, we do believe we’ll see increasing attempts by policy makers to boost domestic growth, beyond the quantitative easing which has seen currency devaluations by the back door.
For example, there are pressures for more protectionism and, in terms of relieving inequality, discussions are much more commonplace around fiscal expansion, helicopter money, higher minimum wages or a Universal Basic Income, guaranteeing a basic level of income for every citizen, which was voted on, but not passed, in Switzerland recently.
In summary, we believe the political landscape in many regions of the world will change materially and this might lead to dramatic shifts in the investment environment. As a result, more than at any time in the recent past, investors need to be alert to political risk.
That said, we view political risk as something to be avoided and diversified away, rather than a source of return generation, given its opaque nature.
Anthony Rayner is a fund manager in Miton multi asset team. All the views expressed above are his own and should not be taken as investment advice.
