Economic theory suggests that political uncertainty affects countries’ expected cash flows. Highly rated countries (low political uncertainty) have higher expected cash flows. The same is true for economic policy uncertainty: Highly rated countries (low economic uncertainty) have higher expected cash flows. Economic theory also suggests that political and economic uncertainty are reflected in discount rates (required risk premiums), with highly rated countries (low uncertainty) having lower discount rates and therefore higher valuations. These lower discount rates result in lower expected returns – risk and expected return are positively correlated. The result is that countries with greater political and economic uncertainty (investment risk countries) should have higher expected returns.
To test whether the theory is consistent with empirical evidence, Vito Gala, Giovanni Pagliardi and Stavros Zenios, authors of the study “Global Political Risk and International Stock Returns” published in June 2023. output of Journal of empirical financeexamined whether political-political uncertainty predicts fluctuations in stock market returns between countries. They constructed a “P-factor” that accounts for “two distinct but related dimensions of multifaceted political risk”: government instability, ie, election risk; and uncertainty about its economic policy, ie political risk.” They integrated these two measures of political risk (political-political) into a bivariate risk factor (P-factor). They plotted politics-politics using survey-based measures of political stability and confidence in government economic policies ifo World Economic Survey (WE S). The survey provided data on the economic, financial and political climate in 42 countries and covered the period 1992-2016. Policy ratings ranged from 1 to 9 for the most politically stable countries and from 0 to 100 for the countries with the highest confidence in government economic policies.
The authors sorted the countries first according to the less volatile politics and then according to the more volatile politics. They then constructed the P-factor as the return on an equally weighted, zero-cost, tradable portfolio, taking long positions in the countries in the bottom tertiles of politics and politics and short positions in the countries in the top tertiles. The portfolios were based on the last day of the month of each WES announcement and were rebalanced semi-annually. Here is a summary of their key findings:
Political and policy uncertainty predicted equity market variability across countries – policy-policy ratings predicted economic growth and stock market returns in each country, and the use of both policy-policy measures improved the identification of policy risk factors. High political and political ratings predict high future cash flow growth. They estimated that raising a country’s policy score to the next quartile would, on average, result in a 0.52% (0.80%) increase in future annual GDP growth. High political and political ratings also forecast low future volatilities.
Compiling country portfolios, sorted by their policies and/or their ratings, resulted in a monotonic cross-section of portfolio returns in both dimensions. The low-policy portfolio outperformed the high-policy portfolio by a statistically significant 6.48% per year, and the low-policy portfolio outperformed the high-policy portfolio by 5.94% per year, with similar Sharpe ratios .
Global ratings showed significant fluctuations over time and deteriorated with significant political or economic policy shocks having an adverse impact, indicating strong spillovers between countries.
The bivariate spread portfolio, which had long positions when politics-politics is low and short positions when politics-politics is high (P-factor), produced a statistically significant average return of 11.10% per year and a Sharpe ratio from 0.53.
Exposure to global and local risk factors from six prominent asset price models failed to account for policy and policy predictability. Tests showed that differences in return between politics, politics and politics-politics portfolios were not due to risk premia on existing factors.
By expanding the global market portfolio with the P-factor, pricing errors have been significantly reduced and cross-section matching has been improved.
Political uncertainty impacted returns through both cash flow and discounting channels. They showed that political ratings affect the discount rate by showing that they predict future market volatilities at six and 12 month horizons. For the 12-month investment horizon, they estimated that an increase in a country’s policy ratings to the next quartile would, on average, result in a 1.73% (3.24%) decline in future annual stock market returns.
The correlations of the political-political variables with 16 other macroeconomic and financial variables from the WES data are small and insignificant. One political factor among the 16 variables still had a large and statistically significant premium.
In robustness tests, the authors confirmed their results using alternative measures of political risk – the International Country Risk Guide (ICRG) country ratings, the economic policy uncertainty index (EPU) and the World Bank’s political stability indicators (WB).
Their findings led the authors to conclude: “Political uncertainty around the world, while originating locally, leads to shared systematic variances between countries, resulting in a priced-in global political risk.” …Asset valuation tests confirm, that global political risk is priced in.” They added: “We empirically confirm that political-political ratings predict economic growth and stock market returns in all countries, and using both political-political measures improves the identification of political risk factors.”
Insights for Investors
Economic theory suggests that countries with greater political and economic uncertainty (investment risk countries) have higher expected returns (though not guaranteed). Not surprisingly, the empirical evidence shows that countries with greater political and economic uncertainty have produced higher returns, as risk and expected return were positively correlated. There’s no such thing as a free lunch for investors seeking higher returns — they have to take on more risk. Another key finding is that Gala, Pagliardi, and Zenios have shown that lower policy uncertainty increases expected future cash flows (which increases stock prices and increases realized returns), but decreases expected future returns.
Larry Swedroe is the author or co-author of 18 books on investing. His latest is Your essential guide to sustainable investing. All opinions expressed are his opinion solely and do not reflect the opinion of Buckingham Strategic Wealth or its affiliates. This information is provided for general informational purposes only and should not be construed as financial, tax or legal advice.
