With political risk looming large over markets over the past few years, Schroders’ global head of multi-asset investments Johanna Kyrklund believes there will be little let-up in the coming months.
In Europe, Brexit negotiations are ongoing but the news that anti-establishment party Five Star Movement and far-right group League will make a coalition has further troubled markets.
Meanwhile, US president Donald Trump has pressed forward with protectionist policies including trade tariffs on a number of key partners including Canada, Mexico and the EU.
“Political risk is always difficult because we can’t predict what Trump will tweet next or what the Italians will do next,” Kyrklund said.
“I think generally markets tend to suffer from attention deficit disorder and focus on key events but ultimately political risk is a chronic risk that plays out over months rather than days.”
So far this year, markets have struggled higher, with the MSCI AC World index up just 3.16 per cent in sterling terms.
Performance of indices over YTD
Source: FE Analytics
The S&P 500, the largest market in the index, has gained 5.55 per cent while negative press surrounding Europe has seen the MSCI Europe ex UK lose 1.16 per cent year-to-date.
Kyrklund said: “If we think about the protectionist rhetoric it has been going on for pretty much since Trump was elected.
“The approach we take to it is that we think it is serious and that it will continue as we head into the mid-term elections and so we can’t discount it – it is a potential headwind for growth.”
All investors can do is attempt to benefit from this by “buying the rumour and selling the facts”.
For example, at the back-end of last year investors were more relaxed about protectionist policies and markets rallied.
During this time she took a position to go long US dollar versus the Canadian dollar to protect against a potential NAFTA (North American Free Trade Agreement) risk, which bore out in February.
However, currently the market is pricing in this risk, making hedges against it relatively unattractive.
“At the moment we are fading protectionist risk but if the market gets complacent we will be looking to re-establish hedges, especially as we move towards the mid-term elections,” she said.
Instead, the fund manager said one area she is more positive on is emerging markets, which have suffered this year for a number of reasons, but mainly over impact of any potential US tariffs.
“More recently we have seen emerging markets struggle for a number of reasons but part of it is rhetoric from Trump and now I think emerging market assets have repriced a little bit,” she said.
The MSCI Emerging Markets index has recovered somewhat recently and is up 15.59 per cent over the last 12 months in local currency terms, yet despite this Kyrklund said it remains one of her preferred areas.
Much of he reasoning is to do with the dollar, which she noted is having a “disproportionate level of impact on markets”.
The manager said: “Last year we shifted to a negative view on the dollar and that was because we felt it had got very expensive and the level of monetary divergence required to sustain it wasn’t going to come through.
“More recently we have had a bit of a rally in the dollar and we view that as a counter-cyclical move and it is really driven by concerns in Europe and a flight to quality bid.”
Performance of currencies over 2yrs
Source: FE Analytics
As the chart shows, the dollar appreciated strongly until 2017 before weakening since, particularly at the start of this year, although it has rebounded somewhat over the last two months.
“Our bias is still to think that the dollar should be fairly weak and that is quite supportive of emerging markets because a weaker dollar typically leads to looser liquidity for global markets as it is reflationary. It also means there are potential benefits for emerging market currencies,” she said.
“[Additionally] emerging markets are in a more benign part of their cycle and there is potential for growth to improve.”
While protectionist policies in the US are somewhat priced in by the market, one area that is not being fully appreciated is the risk surrounding the Italian elections.
“US political risk is talked about extensively and we have the risk of protectionism starting to come out and what that means for global growth but I think that to some extent a risk that is still underpriced by the market is what is going on in Europe,” Kyrklund (pictured) said. 
“In particular in Italy, where you have seen the formation of a coalition government that has history of being very anti-Europe. They are setting themselves on a collision course with Brussels.”
She added that within the EU there are very tight fiscal rules, but Italy’s huge level of debt has been cause for concern.
“It has been put under pressure by Brussels to control its fiscal situation and effectively the coalition government in place now is fighting against that,” the manager said.
“So, although they may say at the moment that they are not anti-euro, what they are choosing to do is flout the rules of the EU and this is a risk that is likely to flare up in the months to come and something to keep an eye on.”
As such, while Europe looks cheap when compared to more expensive markets such as the US, this is for good reason as the risks are under-appreciated.
“For now we are not tempted by European equities,” she said.
Overall, it is important for investors to remain diversified in case some of the risks highlighted above do come to fruition.
Recently, she noted that the multi-asset team have been rotating into US Treasury inflation-protected securities (TIPS) as well as commodities, as they believe the market is now late-cycle.
From a risk-reduction perspective, currencies have played a major role in reducing volatility, while they have avoided traditional safe havens such as government bonds.
“It is important to become more diversified. Valuations are becoming more stretched and it is better to spread risk now across a number of positions. We need to start making a plan for more difficult market environments,” Kyrklund said.