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Image: Shutterstock.com

Image: Shutterstock.com

What is the price of political uncertainty?

10 September 2019

9 minute read

Phong Nago

Dr Phong Ngo 

The effect of global political uncertainty on equity prices increases with a country’s equity market exposure to foreign investors. This, combined with high levels of US investment in Australia, means we are set for a bumpy ride in the lead up to the 2020 US elections, writes Dr Phong Ngo.

Political uncertainty is broadly defined as the uncertainty around future government policies and actions.

While uncertainty is a natural feature of any political process, the recent surge in political uncertainty has been largely self-inflicted. In Australia’s case, the recent dysfunction within the two major political parties has seen seven different Prime Ministers take office in the past decade.

So what is the economic impact of an uncertain political climate? Empirical evidence suggests that the impact is negative, even if only temporary, with uncertainty depressing capital investment by firms, reducing the number of firms going public, and lowering the level of merger and acquisition activity.

To understand how political uncertainty impacts investors in these companies, researchers have studied equity markets, with market prices revealing how investors assess the impact of political risks on economic activity into the future.

Market prices reveal how investors assess the impact of political risks on economic activity into the future.

The extent of political uncertainity

While confirming that investors, too, pay a high price for uncertainty, existing work has focused exclusively on measuring the impact of domestic political uncertainty on domestic asset markets. That is, it has typically asked “what is the impact of Australia’s political uncertainty on the Australian financial markets?”  

However, casual observation suggests that political events in one country can affect asset markets in another country. For example, stock markets around the world rebounded by around 2% on January 2, 2013, following a last-minute deal by the US Congress to prevent tax increases and federal budget cuts.  

Likewise, in the run-up to the 2016 US Presidential election, global markets tumbled on news that Donald Trump had closed the gap on Hillary Clinton. Even as I write this article, I hear of news that the Australian stock market has lost 1.3% (or $24 billion) on the back of escalating trade hostilities between US and China.

Despite this anecdotal evidence, the question remains: Does political uncertainty in one country systematically spill over into others? Moreover, can political risk be global—affecting multiple countries simultaneously—rather than local? My co-authors and I tackle this exact question in a new paper.

The effect of global political uncertainty on equity prices increases with a country’s equity market exposure to foreign investors.

We do this by measuring global political uncertainty using the US election cycle. Elections are associated with a possible change in party control and policy direction and, therefore, spikes in political uncertainty. We use the US elections as a proxy for global political uncertainty because the US is the world’s largest and most influential economy, and thus its federal elections are globally important events. US elections also occur at predetermined time intervals and with sufficient frequency and consistency, which are ideal circumstances for us to estimate an effect. 

We use 35 years of data to show that, in the 6 months leading up to a US election, monthly equity returns in 50 non-US countries are, on average, 1.4% lower than they are in other periods. Moreover, the impact of global political uncertainty dominates that of domestic political uncertainty meaning that, in our sample, US elections matter more than domestic elections. 

Why is this the case?

Global political uncertainty can influence equity returns through two fundamental channels: shocks to expected cash flows; and/or shocks to discount rates. Cash flows can be sensitive to government policy. For example, the 2016 US presidential election result signalled a new era of inward-looking policies that may lead to the deterioration of US trade relations with other countries, thus influencing the cash flows of non-US firms reliant on US trade. Alternatively, global political uncertainty might affect discount rates by raising investors’ risk aversion. Prior research shows us that investors’ risk aversion can shift substantially when faced with external shocks, leading them to sell risky assets like stocks.

Uncertainty associated with Australian politics leaves us vulnerable to global political shocks.

In trying to determine which of these channels is dominant, we show that during the same 6-month pre-election period, equity market volatilities rise, local currencies depreciate (against the US Dollar), and sovereign bond returns increase.  

Moreover, we find that the effect of global political uncertainty on equity prices increases with a country’s equity market exposure to foreign investors (i.e. the magnitude of US or foreign ownership of local equity markets). However, it does not vary with the country’s international trade exposure (i.e. how intensively a country trades with the US).

Taken together, the results are most consistent with the latter channel: global political uncertainty increases global risk aversion, which leads investors to sell risky equity in exchange for safe assets, such as sovereign bonds.

The implications of this study for a country like Australia are two-fold. First, political uncertainty is not easily diversifiable: Holding a global basket of stocks may eliminate the adverse effects of uncertainty associated with Australian politics but it still leaves us vulnerable to global political shocks. 

Second, even though the US is not a prominent trading partner for us, (about 3% of our exports go there compared to about 30% to China), the Australian equity market receives heavy investment from US and foreign investors. For example, an estimated 45% of institutional investment in the S&P/ASX 200 index is by global asset managers. Since exposure to foreign investors is the determining factor for the size of the US election effect that we document, the implication is that Australia is more exposed to US elections than the average country. 

With Trump having already kicked off his re-election campaign for 2020, Australian equity investors best hold onto their seats, because the second half of next year could be a bumpy ride!

The College is always keen to explore research collaborations with the public and private sector and to reconnect with Alumni. Please get in touch if you would like to know more.

Updated:   11 February 2020 / Responsible Officer:  CBE Communications and Outreach / Page Contact:  College Web Team