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Compass and text: Financial markets tend to underestimate political risks.

Addressing investor questions on political risk

Paul Christopher of Wells Fargo Investment Institute answers some of the questions investors ask him the most about investing and political risk.

August 30, 2017
Paul Christopher
Paul Christopher

Paul Christopher is the head global market strategist for Wells Fargo Investment Institute.

Amidst ongoing global tensions and geopolitical concerns, investors want to know how they may protect their portfolios against political risk. The temptation is strong to try to predict political outcomes around the world and adjust investments accordingly, but Wells Fargo Investment Institute advises investors to resist that urge.

Reallocating a portfolio to address a particular risk can be expensive and undermine a long-term investment plan, according to Paul Christopher, head global market strategist for Wells Fargo Investment Institute. There is rarely only one risky political scenario, and experience shows it’s best to focus on concrete steps to help reduce a portfolio’s vulnerability to political risks of any type and timing. The following questions are ones Christopher frequently receives about investing and political risk.

Q: How do financial markets typically misjudge political risks?

Financial markets tend to underestimate political risks — defined here as the uncertainty that comes from trying to predict political decisions — even though they worry a lot about them. It may seem odd that people would underestimate worrisome scenarios, but political decisions often are so opaque that worrying doesn’t help predict the timing and impact. Even a negative outcome can seem so vague that investors may err on the side of optimism and thereby underestimate the risk.

While low-risk scenarios are often underestimated, when something that once seemed very unlikely actually happens — such as the horrific events on 9/11 — investors start overcorrecting. Then they overestimate the risk of a repeat.

Q: How do U.S. investors perceive international political risks?

Unless political risks occur within or near the U.S., domestic investors tend to shrug off the likelihood of these risks having an impact on their investments. But investors should be aware that risks exist around the world, as well as in the U.S.

Since the North Korean intercontinental ballistic missile test in July and subsequent back-and-forth dialogue by both countries, U.S. investors have become more interested in the market risk on the Korean peninsula. While the risk has existed for decades, it’s becoming more real to investors now because of the talk of potential missile strikes on U.S. territory.

Q: Do domestic political risks matter for markets?

Political polarization and stress are growing here at home and, in our view, are largely the result of sluggish income growth since the 1980s. Greater global competition has created frustration and disagreement about the best domestic solutions. As political opinion and congressional negotiations become more polarized, there is a greater chance of inertia on public policy and increasing risk of violence in the public square. Financial markets could begin to notice these as adverse.

Q: Is uncertainty ever a good thing?

Market timing rarely works, and we don’t suggest this. Rather than trying to foresee the timing and impact of a particular and obscure scenario that may not occur, Wells Fargo Investment Institute recommends that investors consider hedging more generally with a broad diversification — one that includes U.S. and non-U.S. exposure, and financial and nonfinancial assets.

We believe the best way for investors to deal with uncertainty is to allocate with an assortment of diversified assets, which are balanced to your tolerance for a wide variety of risks. Diversifying doesn’t just mean tactics like moving stocks into bonds, pulling funds out of financial assets and putting them into property, or selling U.S. dollars and buying other currencies around a particular risk. Putting all or most of your eggs in one proverbial basket can impede investment results and the ability to achieve long-term goals. Over time, a diversified portfolio is likely to increase more in value than one that produces more volatile returns, which is the likely result of being concentrated in a single asset.

Q: Do economic fundamentals carry more weight than political risks?

Underlying economic fundamentals form the engine that moves markets. They are the bedrock of the markets and we believe they carry a greater sustained weight than political risks. Right now, we see the global economy as still growing at a slow but sustainable rate — interest rates are still relatively low, and credit is still widely available.

If you look back to the start of 2017, investors were expecting three things:

  1. Reflation — a stronger stimulus from the government.
  2. A robust economy.
  3. Liquidity — low interest rates, with an ample supply of money for the markets, producing higher family net worth and more cash for companies to spend and invest.

The first of these three hasn’t really materialized. We haven’t seen that robust government stimulus. And, while the economy is certainly solid, it’s not great. But, it’s that third piece, liquidity, which has really driven market growth. Liquidity can be thought of in many ways, but concretely implies that households have more savings available to invest, and that companies have enjoyed rising profits for dividends, mergers, and share buybacks. These factors have supported persistent market gains since mid-2016, despite the greater perception of political risks at home and around the globe.

Q: Which geopolitical risks are you watching out for on the horizon?

There are a number of potential global problems ahead that we’re monitoring. The biggest is the conflict between North Korea and the U.S. While financial markets have responded with a tepid pullback so far, we continue to see signs of diplomacy and believe a negotiated de-escalation is still more likely. But it’s important to remember that war isn’t the only risk, and others may affect markets sooner.

Here are some other areas of potential concern in the future:

  • Spillovers from multiple conflicts in the Middle East.
  • Russian-supported separatism in Ukraine.
  • Italian election outcomes that could spell a potential eurozone breakup.
  • Disruption in China over debt issues.
  • New stress in the South and East China seas from China’s territorial claims over small island chains.
  • Terrorist attacks in the U.S. and Europe.

Q: How may international investing help support a portfolio?

It’s important for investors to understand cycles. We think we’re in the final third of our business cycle in the U.S., but Europe and Japan are probably closer to the first third — the beginning of their cycles. If the U.S. has a recession in the next few years as we expect, for instance, Europe and Japan may be positioned to grow.

Q: Why is diversification so important?

A diverse portfolio also includes many of the asset classes that historically have had positive returns during periods of global risk aversion, including multiple currency exposures, bonds, commodities (including gold), and local companies whose domestic orientation may insulate them better from international political upheaval.

Diversification — one of the six key steps suggested in the report Political Risk, Portfolios, and Perspective (PDF) to mitigate political risk — may benefit a portfolio regardless of whether the political risk has a positive or negative outcome. Wells Fargo Investment Institute recommends portfolios with diversified assets that may reduce a combination of risks, but that are varied based on the investor’s unique risk and return objectives

Q: Can investors become immune to political risk?

No, and it’s important to underscore this point. Investors can’t be fully immune to particular political events. Instead, diversification is a response to the difficulty of systematically and regularly predicting the reactions of particular markets to particular political events.

Read “Geopolitical Tensions Flare – What Investors Should Do” and visit Wells Fargo Investment Institute for more investment education and insights.

Risk Factors

All investing involves risk including the possible loss of principal. There is no assurance any investment strategy will be successful or that a fund will meet its investment objectives.

Diversification cannot eliminate the risk of fluctuating prices and uncertain returns. Diversification also does not guarantee profit or protect against loss in declining markets.

Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.

Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities.

Investments in fixed-income securities are subject to market, interest rate, credit/default, liquidity, inflation and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.

Cash alternatives typically offer lower rates of return than longer-term equity or fixed-income securities and provide a level of liquidity and price stability generally not available to these investments. Some examples of cash alternatives include: Bank certificates of deposit; bank money market accounts; bankers’ acceptances, federal agency short-term securities, money market mutual funds, Treasury bills, ultra-short bond mutual funds or exchange-traded funds and variable rate demand notes. Each type of cash alternatives has advantages and disadvantages which should be discussed with your financial advisor before investing.

Exposure to the commodities markets may subject an investment to greater share price volatility than an investment in traditional equity or debt securities. Investments in commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. Products that invest in commodities may employ more complex strategies which may expose investors to additional risks.

General Disclosure

Wells Fargo Investment Institute, Inc., is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by WFII. Opinions represent WFII’s opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. WFII does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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