2016 will likely have its own chapter in future modern-political history textbooks. It seems fair to say that the political pendulum has swung hard and fast away from a global and free trade focussed politics towards a more nationalist and protectionist school of thought. The outcomes of the British referendum, the U.S. federal election and more recently the Italian constitutional referendum have shown that voters in the Western hemisphere are opting for significant societal change at the ballot box. The failure of the broader media and polling agencies by continuously discounting any reasonable chance of these events occurring (US/UK) added to their shock factor on people and markets. What surprised some market watchers more than the actual events, however, was the market’s reaction to them. It would have been a difficult task to convince someone before the U.S. election that both Trump would win and that in the days preceding, the S&P 500 would rally to all-time highs. Similarly, whilst the outcome of the Italian referendum was not a surprise, it raised eyebrows when people saw the Euro and Italian markets rally after the result.
Political risk is now front and centre in investors’ minds after decades of relative stability in major nations. Whilst some significant shifts have occured in global politics, a number of new political seismic shifts could take place as historically important elections loom in the Netherlands, France, Germany, Catalonia and Italy. In this report we will look at a number of elections which have the potential to change the investment landscape for decades to come, who the leading candidates and parties are as well some of the outcomes that could result from them. Assessing the political landscape is an important yet difficult aspect of investing and particularly vital when looking at broader asset allocations and companies with specific country exposures.
French Elections:
An upset of sorts already occurred in the lead up to the French national elections with Nicolas Sarkozy’s former Prime Minister, Francois Fillon, winning the Republican primary in November. Bordeaux mayor and prolific EU supporter Alain Juppe had been widely tipped by pollsters to be elected as the Republican’s candidate. Fillon has been described as classic small-government conservative, expressing his wishes to get rid of 500,000 public sector jobs, reduce various taxes and lower welfare spending. Whilst openly critical of the EU with regards to immigration, trade and sovereignty, he does not advocate leaving the union.
Trailing behind Fillon in the opinion polls by a few points in a field of 11 candidates is the National Front’s Marine Le Pen. The daughter of the founder of her party, Jean-Marie Pen, is known for having strong far-right and nationalist political views. Her political agenda would spell a significant upheaval for the country: halting immigration, introducing economic protectionism and leaving the E.U.
Her party is running of the back of a number of successes in the EU elections in 2014 and more recently in the French regional elections. However, Le Pen currently trails Fillon both in the polls and betting markets, albeit by a margin smaller than Brexit and Trump (not to suggest that markets may have already adjusted after these unexpected results). Whilst these two indicators might suggest an air of comfort be appropriate, the tight margin and multiple parties mean that the risk of a far-right party taking power in France is not negligible.
French Federal Election Opinion Polls
Figure 1. French Federal Election Opinion Polls
Source: bva.fr 07/12 & lfop.fr 06/12
 
Italian Elections:
With the Italian constitutional referendum concluding last Sunday, we learned that the Italian people voted to not change laws which govern the split of powers between the houses of parliament and the states and regions. What was particularly notable about this result was that soon to be ex-prime minister, Matteo Renzi, had announced his support for the bill to the public and said he would resign if it was voted down. Subsequently, some suggested that the vote became more than one just about political reform, it also became a vote of confidence in the youngest prime minister in Italy’s history.
Hot on the heels of the Democratic party in Italy is the populist party known as the Five Star Movement. It was founded by celebrity comedian and blogger Beppe Grillo with five key policy areas focussed on water, transport, sustainable development, internet access and environmentalism. The Five Star Movement is not as strongly anti-EU as some of the other European populist parties, given it does not hold an official position its membership, yet describes itself as ‘Eurosceptic’ and would consider a referendum. This is considered an unlikely proposition with only 15% of Italians supporting an exit. Whilst some commentators point out that Italy could stay within the EU with a FSM party in power, it remains to be seen how a populist movement would deal with potential events such as the capital issues at major banks or even the nationalization of a major bank. If history is anything to go by, Germany and Brussels may show little appetite to negotiate with an incoming populist party (i.e. Greece).
The Italian election is due to be held on 23 May 2018 at the latest. Currently, the Five Star Movement trails the Democratic Party by less than a percent in the opinion polls. Although, due to Italy’s unusual electoral system, whilst receiving more votes than the Democratic Party at the last election, the FSM received only slightly more than a third of their equivalent seats.
Italian Poll of Polls – Feb 2013-Aug 2016
Figure 2. Italian Poll of Polls – Feb 2013-Aug 2016
Source: Wikipedia
 
German Elections:
Based off German law dictating the timing of the next election after parliament’s first sitting, the German people will head to the ballot box between August and October of 2017. The primary issues which are shaping up to influence voters at next year’s election include migration, terrorism, Russian sanctions and the country’s role in the Eurozone. The EU’s main power-broker and German Chancellor, Angela Merkel, has faced a popular backlash as a number of far right wing parties rise in the polls, most notably the Alternative for Germany (AfD). Chancellor Merkel’s Christian Democratic Union has been experiencing a constant decline in the polls since the European refugee crisis began in mid-2015 as the media has pinned a lot of the blame on her shoulders, yet she continues to maintain a strong double digit lead.
Whilst not posing as big a risk of winning the election on current polling as some of the other rising populist parties in Europe, the AfD has seen a tripling in its polling numbers in the last 12 month – from approximately 5% to just under 15%. The party has been described as nationalist, right-wing populist, conservative and a strong Eurosceptic. In news that Merkel will surely welcome, however, infighting within the party in 2015 led to a split between those who were more strongly anti-immigration versus those who were more attracted to the economic policies of the party. This resulted in the establishment of the Alliance for Progress and Renewal by former party Chairman Bernd Lucke.
In a similar fashion to Five Star Movement, the AfD consider themselves as Eurosceptics although do not advocate for Germany to leave the EU. In recent times, the party has been attempting to push back against its right-wing radical branding by stating that it is excluding those with strong right-wing, anti-EU leanings from joining their party – many of whom were formally members of the National Democratic Party. As such, it seems unlikely at this point that the upcoming German elections could meaningfully alter the country’s membership of the EU.
German Poll of Polls – Sep 2013-October 2016
Figure 3. EU – German Poll of Polls – Sep 2013-October 2016
Source: Wikipedia
 
Netherland Elections:
Gert Wilders’ Party for Freedom has been through a rapid climb on the Dutch political ladder since first winning seats in the 2006 election, after forming the party as an independent member of parliament. His party has been described as nationalistic, right-wing populist, anti-immigration and euro-sceptic. It has held a consistent lead in the opinion polls for over a year heading towards the election in March. He currently holds a very strong position in betting markets, priced at $1.36 to the incumbent Rutte’s $3.60.
The Party for Freedom’s anti-EU sentiments and intent to push for a referendum on the issue could pose risks to a country has one of the busiest ports in the northern hemisphere and the biggest in Europe. As is illustrated below, potential issues also arise given the Netherlands has one of the highest proportions of its international trade with fellow EU members.
EU – Intra EU and extra EU export of goods, EU member states, 2013
Figure 4. EU – Intra EU and extra EU export of goods, EU member states, 2013
Source: Eurostat
In terms of the EU, the Netherlands voting to leave would be considered a massive blow, losing its 5th largest member who generates almost 5% of the EU’s GDP and a net contributor of two billion Euro (avg. 2007-2013) to the union’s budget each year. Whilst the Netherlands voting to leave the EU may not be enough to mortally wound the band of nations, it certainly would place massive budget constraints and create further division within Europe.
EU – Poll of Polls, Netherlands General Election 29/11 (VVD current ruling party, PVV G. Wilder’s Party) – Forecast Seats
Figure 5. EU – Poll of Polls, Netherlands General Election 29/11 (VVD current ruling party, PVV G. Wilder’s Party) – Forecast Seats
Source: University Leidan
 
With a litany of upcoming elections in 2017 and 2018 in Europe, it is clear that the wave of anti-establishment politics that has gripped the Western Hemisphere is set to continue. Given the measurement of political risk is a more subjective measure than say its economic counterpart, markets have been historically quite poor at pricing such risks in the lead up to major paradigm shifts. As we have observed after the various elections this year, not only have results caught many in the market off-guard, but the subsequent reactions of capital markets have been the opposite of what conventional wisdom would posit. In addition to the elections listed above, further rounds of debt-negotiations between the EU and Greece will be taking place at the end of this year, into next, and Catalonia is planning to hold a referendum to make itself independent of Spain. Political risk is ultimately difficult to measure but it is clear that tensions are rising to the surface and that could have significant impact on global capital markets.
In looking at how we address this risk when managing our portfolios, we aim to take advantage of the elevated levels of volatility, both on the upside and downside, to gradually trim or add to positions. For example, during the intraday sell-offs during the Brexit and US election votes, we incrementally lowered our cash positions as we invested into our preffered portfolio names. Subsequently, as markets recovered and continued to rally in the coming weeks, we were able to lighten positions in some of the names we added to, bringing our holdings back to model weights. Whilst on the surface this may seem to go against a traditional value-investing philosophy, it is important to take the quantum of the market moves in reference to average long term stock-market returns. When the market moves between 3-5% in one session, the value of your equities are undertaking close to 12 months of price action in a single day (given a 10 year return on the All Ords Accumulation index of 4.76%). Generally speaking, our mantra during periods like these is to maintain a decent cash weighting as markets continue to rally, executing opportunistic buys and sells on days where volatility in the market jumps.