Among the many factors that can affect market performance, political events are perhaps the most difficult to predict, but they frequently have significant implications for investment decisions. Financial markets generally abhor political instability. At the same time, a thorough analysis of political forces at work may uncover unanticipated opportunities or avoidable risks.

What is political risk?

Political risk – sometimes known as geopolitical risk – is the risk that political decisions, changes or disruptions may have a meaningful impact on the performance of a company or government. Political risk is not restricted to country-level incidents, but rather can encompass local, national, regional and global events.

Political risk can come from any number of sources, such as:

• Policy decisions and shifts affecting things like trade tariffs, taxes, labour conditions, privatisation and regulation
• Political leadership changes and government instability
• Political volatility and uncertainty stemming from terrorism, riots, coups or war.

Political events or sudden policy shifts can disrupt a company’s ability to execute strategy and deliver products or services. In turn, this can affect company performance and profitability. The effects can be negative or positive.

For example: A change in a country’s tax structure, minimum wage or regulatory requirements could raise costs and, depending on a company’s ability to pass those higher costs on to consumers, have an unanticipated impact on earnings. Or a shift in trade laws for a particular industry – such as the liberalisation of trade restrictions on the export of U.S. oil and gas – could result in potential opportunities to expand trade with overseas business partners.

In other words, political risk and instability can influence trade with other countries. It may deter foreign investors from wanting to invest in the debt and equity securities offered by companies or government entities based in the region. Or it may portend an opening of new markets.

How are financial markets affected?

Like any other form of market risk, political risk has the potential to influence the performance of individual securities as well as the market more broadly.

For equity markets, political risk could cause the share price of a company to decline significantly. For example, an unexpected decision by a government to change the privatisation laws of a particular industry could cause companies in that sector to be hit substantially.

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Meanwhile, broader political instability or changes – perhaps due to an unwelcome or controversial change of government – could generate concern among investors and cause a broader market decline.

For fixed income markets, political risk can create problems for both corporate bonds and government bonds. For companies, a decline in performance or profitability resulting from political risk could leave a company unable to pay its debt obligations and hence, increases the risk of default.

For government bonds, increased political risk can push bond yields up as investors demand higher returns as compensation. Historically, this has been more of a problem in developing nations, where the risk of default or debt restructuring may be higher, although events of the past few years (Brexit, Italy’s constitutional referendum) have demonstrated that political risk is a crucial factor for developed economies as well.

How is political risk measured?

Political risk can be very hard to quantify because of limited availability of data and case studies. Nevertheless, PIMCO believes it is an extremely important risk to assess, especially when investing in foreign countries, and includes an evaluation of key political risk factors as part of its quarterly cyclical and secular outlooks.

Some risk analysis firms, such as Eurasia Group and the PRS Group, model political risk and produce political risk indices. Available online, these resources can help guide investment decisions.