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Investment themes and the impact of political risk

1/3/2017

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As we move through early 2017, we are very aware of the recent equity market rally, with a strong “Trump bump”, or “Santa Claus rally” going into the end of 2016. Nonetheless, we are conscious of potential market headwinds ahead, such as Brexit, President Trump and his policies and a heavy electoral calendar in Europe at a time of rising support for populist parties.
 
In retrospect, a lot of themes had a substantial impact on the market in 2016, none more so than political risk. 2016 will be remembered as the year that the UK voted to leave the European Union and the USA elected Donald Trump to be their 45th President. Both results surprised the markets, particularly as opinion polls didn’t predict either outcome. They could be seen as part of a wider trend of increasing support for populist politics, particularly in the European Union, however there were also specific reasons why it is too simple to attribute these results solely to a rise in populism.
 
The consequence of these elections will dominate markets in 2017, and for years to come.
 
The interesting thing about both major political surprises is that the markets took them in their stride. Equity markets, particularly in the US and UK, finished the year at, or near, all-time highs. This is in stark contrast to equity market performance at the beginning of the year.
 
Brexit revisited: The biggest issue surrounding Brexit is still the uncertainty over when it will happen, and in what form it will occur.  Prime Minister Theresa May had previously signalled her intention to trigger Article 50 of the Lisbon Treaty by the end of March 2017, starting a two-year window of negotiations which meant the UK would therefore have been out of the European Union by April 2019.
 
However, there have been legal challenges heard in the High Court and then the Supreme Court, it is also unclear as to whether the House of Lords may try to delay or derail the process.
 
Article 50 states that there is only 2 years allowed for negotiations. It seems unlikely that the UK and EU negotiators will come to terms on all EU laws and regulations within a two-year period, which raises the question about would happen at the end of the two years if there are still issues outstanding.
 
Throughout the negotiations, there will be plenty of discussion about how this will affect the UK economy and markets.  Will a weaker Sterling push up inflation to the point where the Bank of England should consider raising rates to keep it within check? Will the UK economy struggle due to lack of access to the Single European Market?  How will the City cope if it doesn’t have passporting rights to do business in the EU?
 
As with most issues, investors fear uncertainty, although this could provide opportunities, particularly in UK equities, which are close to all-time highs on sterling weakness and a rebound in commodities.
 
While we still await details of how Brexit is going to play out, a period of substantial market volatility would not be surprising.

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    Author

    Director, David Hardman has over 20 years experience in financial services.

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