GL_I_PolRisk_1

This article was first published in the April 2017 international edition of Accounting and Business magazine.

Not long ago political risk was something to be worried about only when investing in developing nations. That changed in 2016 after the Brexit vote in the UK and the election of Donald Trump in the US showed that upheavals could happen in rich nations too. After a year of turbulence, it is now Europe’s turn to go to the polls. In Germany, Angela Merkel is battling to win a fourth term as chancellor. Elections in the Netherlands, France and possibly Italy have the potential to rattle businesses still more by handing power to populist parties that favour a withdrawal from the European Union or the single currency. 

‘Investors and businesses may need to brace for a rocky ride in 2017,’ says Stephen Brown, a European analyst at Capital Economics. ‘While Europe’s elections could go smoothly, they could also threaten the entire European project, and that would have huge implications for the economy.’ 

So how great is the danger and is there anything that companies can do to prepare for possible turbulence ahead? 

The main concern for businesses is that financial markets are likely to respond swiftly to a rising threat to the euro or to the EU itself. ‘There are a number of increasingly well-supported political parties that want their nations to follow Britain’s lead out of the EU,’ says Marc Chandler, chief currency strategist at Brown Brothers Harriman in New York. ‘If it starts to look more likely that one of these populist groups will gain power, the gut reaction of investors will be to sell the bonds of more vulnerable nations – such as Italy or Spain.’

The spectre of capital flight

This in turn would boost borrowing costs for governments and companies, a potential drag on growth. At the same time, if European citizens start to fear that their euros could be exchanged for less valuable domestic replacements – such as a reborn French franc or Italian lira – many would withdraw their savings from domestic banks and deposit them abroad. This capital flight would then put strain on the banks, making them less able to lend money. ‘Europe suffered from exactly these problems in 2010 to 2012 amid worries that heavily indebted nations could be forced to leave the currency zone,’ Chandler says. ‘The result was a serious hit to growth.’ 

On that occasion the European Central Bank was able to calm the crisis, with the ECB president Mario Draghi promising to do ‘whatever it takes’ to save the single currency. 

‘The commitment to buy the bonds of vulnerable nations and push borrowing costs back down helped stop a vicious spiral,’ says Jacob Kirkegaard, a European expert at the Peterson Institute for International Economics in Washington. But he believes it might be harder for the ECB to ride to the rescue again if populists win elections in 2017. ‘If the crisis is caused by voters casting anti-euro votes, it is trickier to justify intervention to solve the problem,’ he argues.  

Populist parties could damage the European economy even if they aren’t able to form governments. ‘Although it is still highly likely that no country will leave the eurozone over the coming two years, that doesn’t mean Europe is off the hook,’ says Capital Economics’ Brown. ‘There are several ways in which these parties could stunt growth without taking over the reins of state.’ 

First, heightened risks of an exit could be enough to push up borrowing costs in nations such as Italy. Rises in the Sentix euro breakup index – which surveys more than 1,000 investors on the likelihood that a member of the currency club will leave – have been linked to rising bond yields in Europe’s periphery. Second, merely gaining seats in national parliaments would give populist parties more ability to slow the pace of economic reform. 

‘The Netherlands, France and Italy are all badly in need of reforms to reduce restrictions on their labour markets, which hold back growth,’ Brown says. ‘That becomes harder if anti-euro populists have more heft.’ 

Finally, the rise of nationalism could reduce the ability of the eurozone to cope with future crises. ‘It was not easy to convince national parliaments to back the debt bailout that helped keep Greece in the eurozone,’ Brown says. ‘It will become more difficult for Europe to help struggling nations if populists have greater strength in parliaments.’ 

To make matters worse, opinion polls are less reliable than in the past, giving businesses and investors less chance of accurately forecasting political outcomes. ‘If you trust the polls, you might think that there was not so much to worry about in Europe,’ says Kirkegaard. ‘For example, it would seem highly unlikely that the French presidency will be claimed by National Front leader Marine Le Pen. The trouble is that investors and business have lost confidence in the polls.’ 

The polling industry has suffered a series of high-profile recent humiliations. Ahead of the US presidential election, the Democratic party candidate Hillary Clinton enjoyed a commanding lead in the polls, with Trump only occasionally pulling ahead. Largely on this basis, days before the vote, betting markets assigned him only a 20% chance of victory. Polls have also proved wide of the mark in the Brexit vote, the 2015 UK general election and the 2016 Spanish general election. ‘The reliability of these opinion measures has been severely compromised by the advent of the cellphone,’ Kirkegaard explains. ‘People are less likely to pick up their cellphone to an unknown number than with landlines, and so the response rate has been falling.’ A 2012 report from Pew Research, one of the most respected pollsters in the US, showed a 9% response rate, compared to nearly 40% in the late 1990s. In addition there are signs that the rise of ‘fake news’ is affecting political events in less predictable ways. 

Adjusting to new norms

That raises the question of how businesses or investors can brace for a potentially turbulent year. One lesson that stands out from 2016 is to hedge risk. ‘For example,’ says Chandler at Brown Brothers Harriman, ‘a UK company reliant on imported parts would have been disadvantaged by the fall in the pound. Stepping up currency hedging in advance of the event could have delayed the pain and given them longer to adjust to a weaker sterling.’ Equally, some eurozone importers may now consider more active hedging against higher costs from a possible fall in the euro in 2017. Companies vulnerable to rising borrowing costs, especially in Europe’s periphery, could consider locking in interest rates on their debt for longer. 

Of course, it is far from certain that 2017 will be a tough year for Europe. One point of reassurance, Brown argues, is that markets and economies may be more resilient than expected. Public support for the euro is still high, with 69% of French citizens and 77% in the Netherlands backing the single currency. ‘Even if populists win elections, they would face a battle to win a referendum on the euro,’ Brown says. ‘It is possible that investors will take this into account and react calmly.’ 

After all, financial markets recovered swiftly from the jitters that followed the Brexit vote and the election of Trump – in the latter case within hours. While uncertainty over elections in Europe will unnerve investors, it is also possible that markets and growth could emerge stronger. In 2016 voters in Spain opted for mainstream political parties over the anti-establishment Podemos; a similar outcome in the rest of Europe would probably be helpful for the economy and markets. In the forthcoming German federal elections, the Social Democratic party’s Martin Schulz – Merkel’s main rival – supports higher government spending and is likely to put more emphasis on fiscal austerity in peripheral European countries such as Portugal and Greece. This could be positive for growth.

Overall, the message for companies is to hope for the best in the elections of 2017 and prepare for the worst.

Christopher Fitzgerald and Fernando Florez, journalists