Are pension schemes prepared for political risk?

For decades geopolitical risk was a minor consideration for investors in the developed world. That all changed last year with the UK's decision to leave the European Union and the election of Donald Trump in the US. Investors are now paying careful attention to the upcoming European elections, nervous there could be further surprises.

But these increased geopolitical concerns are not reflected in financial markets. Equity markets remain buoyant on either side of the Atlantic, with the Dow recently breaching 20,000. Schroders portfolio solutions strategist Alistair Jones says: "Equity market valuations are at multi-year highs while volatility levels remain at very low levels."

Does this lack of concern reflect a cognitive dissonance? Are markets ignoring political risk? Or have they decided this risk is overplayed and other factors are more important? Market signals are contradictory and appear irrational because there are multiple forces at play.

To understand why the market is behaving as it does, it's important to recognise that we are not living in normal times. Comparing current equity market valuations and volatility levels with historic precedent does not take account of the impact of ultra-loose monetary policy.

Quantitative easing has played an important role in underpinning equity market valuations, as investors have used equities as bond proxies, which has reduced volatility, says Jones.

Under the surface of the strong equity market performance, however, there are indications that investors are cognisant of political risk.

Fidelity International investment director Katie Roberts, says: "If you look at which stocks are performing well, it's evident that investors are not completely ignoring political risk - they are selecting more defensive stocks."

And while ultra-loose monetary policy still influences equity market valuations, there are signs that markets are starting to behave in a way that is more consistent with historic norms. "Equity markets are taking greater account of fundamental analysis and economic news than they have done," says Roberts.

The economic outlook and fundamentals are also improving, which provides support for financial markets. Henderson Global Investors head of multi-asset Paul O'Connor, says: "There is an almost Goldilocks-like situation at the moment: growth and inflation are neither too strong nor too weak, they are just right."

This provides just the right environment for companies to boost revenues and increase profits without the central banks having to increase interest rates rapidly, adds O'Connor who says the economic outlook is improving.

"Since the summer of last year, GDP growth, inflation and earnings forecast have all been upgraded, reversing the trend of the last five years," he says. In addition, this improvement is broad-based with all G20 economies growing.

Are markets rational?

While there are signs that markets are behaving rationally - strong economic growth and improving fundamentals provide some justification for the market's current valuation - not all market moves have been so rational.

US equity markets moved sharply up after Trump's election. Rather than worrying whether such a maverick president could create political stability, markets instead focused on his promise of fiscal stimulus.

If Trump delivers on his campaign promises, tax cuts and infrastructure spend should significantly boost the US economy. Markets reacted exuberantly to this news - at the time of writing, the S&P 500 has risen by 10% since the election.

But this optimism may be misplaced. Natixis Global Asset Management chief market strategist David Lafferty, says: "US markets are underestimating the political risk." The ongoing investigation by the FBI into the connection between Trump's team and Russia will, at the very least, continue to hang over his presidency.

In addition, US markets may be placing too much faith in the president's ability to deliver greater stimulus. Lafferty says: "The US does not have fiscal flexibility to deliver on Trump's promises."

Risks to the fiscal stimulus programme are starting to materialise. Trump may well prove to be too weak a president to enact forceful legislative change. Lafferty says: "The market thought this would be a post-gridlock presidency as the Republicans have a clean sweep of the House of Representatives and the Senate."

But US government is still grid-locked - now it is Republicans versus Republicans rather than Democrats versus Republicans. Lafferty says: "It's far from obvious that this government will prove decisive."

The initial signs are not reassuring. The first two forays into legislation have been unsuccessful. Lafferty says: "The American Healthcare Act, which would replace Obamacare, is dead on arrival." And Trump's 'skinny' budget, which slashes Federal spending, was also negatively received by the Republicans.

Trump's potential inability to deliver on fiscal stimulus is not the only political risk that markets are ignoring. Hermes Investment Management chief economist Neil Williams says: "Markets have focused on the positive aspects of Trump's pro-growth policies and ignored his protectionist promises."

While Trump's protectionist promises are not likely to curry favour with the Republican party, he may be able to enact these measures through executive orders, and not require Congressional approval.

Williams says that if Trump enacts his protectionist policies, there is a chance there will be retaliation which then spurs global, and ultimately, US stagflation. Williams says: "History teaches us that retaliatory protectionism is not good to growth and causes cost inflation."

The positive market reaction in the wake of the Trump presidency underlines the difference between the way equity markets are reacting to political risk in the US and Europe. Lafferty says: "Political risk is a bigger problem in the US than in Europe because the prices have already reflected the hope."

The S&P 500 is trading at over 18 times forward earnings while Eurostoxx 50 is trading at only 14 times forward earnings. Lafferty says: "There is a bit more of a buffer for political risk in Europe than there is in the US."

Volatility levels are too low in the US. Lafferty adds: "A late-cycle market with this level of political uncertainty hanging over it does not deserve a Vix level of only 11%."

There are signs that investors are starting to change their minds, with the US markets starting to sell off towards the end of March. Lafferty says: "This was the first significant hiccup in the post-Trump election period. We expect many more."

If US markets are currently underestimating the potential impact of political risk, have the European markets avoided this mistake? The lower price-to-earnings ratios for this market compared with the US indicate this might be the case.

The recent rejection of the far-right candidate, Geert Wilders, in the Dutch election could indicate that concerns over populism are over blown.

But it would be rash to jump to this conclusion, argues O'Connor. "The backlash against globalisation and inequality is a powerful force which is very strong."

While these forces did not result in a major upset in the Dutch elections and might not affect the upcoming French and German elections, they are likely to affect more significant political change in coming years, adds O'Connor.

"Political risk is here to stay and will play an important role in financial markets over coming years," he says.

While none of these factors have yet resulted in systemic risk, uncertainty will continue to overhang the markets and could reshape the macroeconomic environment in the future, he adds.

An overhang of political uncertainty presents a challenge to pension schemes: how should long-term investors factor this into their portfolio design?

Pension schemes can take short- and medium-term steps to insulate themselves from political risk. "Low volatility in equity markets has a major benefit for pension schemes - the cost of protection from equity market shocks is currently at a multi-year low level," says Jones.

Schemes could protect themselves from a 10% market correction by paying only 2.5% over the next year, adds Jones.

There has been a spike in interest in option protection mechanisms from pension schemes, coinciding with many pension scheme valuations happening either this year or next year, he adds.

Many schemes are motivated to lock-in the significant year-on-year equity market gains caused by the collapse in sterling since the result of the European referendum. Jones says: "It's seems a no brainer to use the exceptionally cheap option pricing to lock in these gains if coming up to an actuarial valuation."

Over the medium term, schemes should ensure they build resilience into their portfolio. O'Connor says: "Political risk is going to flare up more frequently than it has done in the past, which will cause market set-backs."

It will be difficult to predict where this risk will arise making diversification the best way to protect against this risk, adds O'Connor.

Pension schemes should also be aware that the weakness of Trump's presidency is not the only reason why hopes for fiscal stimulus leading to a more normalised interest-rate environment might be overblown.

Williams says: "Ultra loose monetary policy will continue, even if the economy improves." The major central banks are still running around $13trn (£10.5trn) of quantitative easing - it would be impossible without unintended consequences to reverse the position over a short period of time.

Many schemes have already acknowledged the reality that monetary policy will remain loose for a long time and adapted their portfolio design accordingly, says Williams.