The Italian Election in 2013 Excessively Roiled Markets

With no party having gained sufficient seats in the upper house of the Italian legislature, analysts warned on February 25, 2013 of a “hung parliament,” which would make it even more difficult for structural and fiscal reforms to be passed. Even though the Democratic Party appeared to have gained a slim victory in the lower house, giving that party the majority of 340 seats out of 630, the upper and lower houses have equal law-making ability so even the possibility of a hung parliament roiled markets. I contend that this is yet another case of financial analysts over-reacting to political uncertainty. 

“It was the worst possible outcome, feared by market participants and European policy-makers alike. Italy is facing Greek-style political gridlock and possibly new elections,” Tobias Blattner said at Daiwa Capital Markets.[1] The Wall Street Journal observed at the time, “Italy’s growth prospects are tepid at best, and the election result demonstrates in spades that its fractious politics has not been masters.”[2] Generally speaking, the parties protesting the fiscal reforms demanded by the E.U. did well, suggesting that Italy could find itself at odds with the federal government in how to resolve the state’s debt crisis.

Italy’s bench market index, the FTSE MIB, traded down 4.62 percent on February 26^th and the euro sank close to a seven-week low against the dollar, trading at $1.31. Yields on 10-year Italian bonds jumped 0.45 percentage point to 4.81 percent. Bonds of Spain, Portugal and Greece were hit too. In America, the Dow fell nearly 300 points on February 25^th, the market’s worst day in almost four months. Markets in the E.U. were down around 2 percent, but futures indexes there and in the U.S. were up the following day.[3]

The optimistic showing of the futures indexes on the day after the election hints that the market on both sides of the Atlantic over-reacted to the anticipated gridlock and possible new election. To an extent, the results are within the range of what can be expected from a multi-party system of parliamentary democracy. Indeed, the states of Britain and Germany had had to form coalition governments just a few years before, and even the problematic Greek elections ended with a government. In fact, that government ended up ratifying the additional austerity.

Moreover, the immediate reaction of the markets seems antiquated to me in the sense that market participants had not adjusted their mindsets to the contemporary European context. In particular, the participants treated Italy as though it were a sovereign state, rather than a state in the E.U. There being a federal level mitigates the importance of state elections even though the states hold more power in the E.U. than the American states hold in the United States. Put another way, the E.U. would surely pressure Italian officials to end the gridlock. Even if the resulting state government were antagonistic to the austerity approach, negotiations would doubtless occur between the state and federal levels. The result would not be as stark or extreme as perhaps market participants presumed in their immediate reactions to the news.

Moreover, such overreactions to political instability may also be due to a projection of relative business certainty onto political turf, which is inherently uncertain even though engrained institutions and constitutions can buffer the turbulence as political dynamics naturally shift and even erupt. Business analysts and investors used to being able to hedge financial and market risk inhabit the business world, which generally does not produce such instability as does the world of politics. In other words, a legislature is generally more rambunctious than is a corporate board meeting. Uncertainty is even in just looking at that other world, as it is so different. This uncertainty, plus novice judgement in political affairs, can explain why political risk analysis may overstate political uncertainty even though it is more than business uncertainty.

1. Charles Forelle, “Italian Election Outcome Sparks Selloff,” The Wall Street Journal, February 26, 2013.

2. Ibid.

3. Alessandra Galloni and Giada Zampano, “Messy Italian Election Shakes World Markets,” Febraury 26, 2013; Katy Barnato, “US Stock Futures Rebound; Italy, Bernanke in Focus,” cnbc.com, February 26, 2013.

The British Pound Reacts to Secession

When the E.U. state of Britain held a vote in 2016 on whether to secede from the union, the British currency plummeted. On the day of the December 2019 statewide election in the U.K., that currency initially jumped and held on the day after as official results confirmed that the conservatives had won a majority and thus would be able to see the secession through. I submit that uncertainty itself was a major factor in both swings, and that the market put too much emphasis on the matter of uncertainty at the expense of the substantive economic effects of secession.

According to The New York Times, the British pound plummeted after the referendum vote in 2016 due to “agitation over the economic and financial disruption that seemed to lie ahead.”[1] Such disruption would be an interim matter, rather than ongoing, because a new equilibrium would doubtless take hold. The agitation was thus about change, and more specifically about the uncertainty that is in any change. Alternatively, the drop in the currency could have been to analysts having determined that the British economy would not be as strong after the change. In other words, the drop could have been prompted by analyses of the new equilibrium more so than the uncertainty during the change. I submit that such a rationale would have been better, for it would have reflected economic fundamentals rather than merely an aversion to change.

The state’s general election in December 2019 took place after a long period of governmental stalemate on the matter of secession. Prime Minister Boris Johnson had secured an agreement with federal officials on a secession plan, but his own state legislature balked. The achievement of an outright majority in the House of Commons in the election meant that Johnson’s plan could finally be passed. The high probability of secession taking place at the end of the next month (and with a trade deal) removed the uncertainty concerning even whether the state would secede. According to Lee Hardman at MUFG, the election outcome “gives you more clarity over the direction of Brexit.”[2] Clarity, rather than how the state’s economy would be post-secession, involves a decrease of uncertainty.

To be sure, the governmental stalemate and the related uncertainty had been difficult on British businesses. Some even moved their headquarters to other states. That Johnson would be able to push his secession deal through his legislature means that the market could anticipate even less uncertainty. So it makes sense that the decrease in uncertainty would be a factor in the currency markets. Even so, what about how the state’s economy would be like after the transition? That the UK would secede with a deal suggested that the state’s economy would not only suffer less uncertainty, but also be stronger, with continuing trade with the E.U.’s states. How would the UK economy look? This, I submit, is what the currency markets could (and should) have reflected to a significant degree relative to the matter of uncertainty and transition.

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1. Amie Tsang and Matt Phillips, “Brexit Once Meant a Weaker British Pound, But Not Anymore,” The New York Times, December 12, 2019.

2. Ibid.

Political Risk Exaggerated on Catexit

On the day the Catalan parliament voted in favor of “Catexit” from Spain, the IBEX-35 stock-market index dropped 1.4 percent while the Stoxx Europe 600 gained 0.3 percent.[1] The IBEX-35 is an stock-index of companies based in Spain. Investors also sold state bonds; yields on 10-year bonds rose to 1.574% from 1.558. Even though these changes were hardly earth-shattering in magnitude, their directionality points to investor-anxiety. I submit that it was overblown, which suggests that investors generally tend to over-react to political events.

Analysts said at the time that the state of Spain and the E.U. were unlikely to recognize the validity of the legislative vote, so the possibility of social unrest accounted for the drop in the index and rise in bond-yields. The prospect of a Catexit was indeed still bleak; in fact, the state government had redoubled its control in the problematic, wealthy region, so even the prospect that social unrest would even ruffle the feathers of business could be said to be bleak. Uncertainty itself was the alleged culprit. The Wall Street Journal observed at the time that the “market selloff reflects fears that uncertainty will be harmful for [the state’s] economy.”[2] The fear of fear itself, I submit, can as in this instance be overblown, given the haziness of the future negative scenarios.

Generally speaking, political risk can be overstated if a political event occurs on a day rather than strung out over weeks or months even though the eventual possible outcomes are far from clear. The publicity from the sheer dramatic flair of an event can magnify the perception of uncertainty, prompting investors not just to stay away, but even to sell.  

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[1] Jon Sindreu, “Stocks, Bonds Hit by Political Unrest,” The Wall Street Journal, October 28-29, 2017.

[2] Ibid.

Business CEO’s Overstating Political Uncertainty in the United States

The impact on business of political uncertainty in countries that are seized by revolution can be substantial—so much so in fact that CEO’s and board directors are motivated to avoid the uncertainty itself. I submit that business analysts of political risk tend unwittingly to routinely overstate the uncertainty arising from incoming U.S. presidential administrations. If I am correct in this claim, CEO’s and board directors pay too much heed to political uncertainty itself in the making of major strategic decisions involving operations in the American context.

Although American culture welcomes and even encourages leaps in technological development capable of transforming daily life, another sort of change—one more subject to societal control—is tolerated only if made incrementally. Otherwise, the change is dubbed as radical, which is a charge made more out of fear than according to any objective measure. Clutching at the status quo unduly translates politically into the tyranny of the status quo as powers both in business and government that profit as things are hold back all but incremental change that does not threaten the current basis of benefits. The many points of access into the federal legislative and executive machinery enable the stultifying influence a virtual veto over proposals of serious, or “real,” change. Such change tends to be pulled back until only the tolerated incremental change remains.

A few examples reveal the pattern. In 1986, amid large budget deficits caused in part by the tax cuts of the early 80’s, Ronald Reagan pushed for a wholesale change in the federal income tax, ridding it of its myriad of deductions. Yet as the U.S. Senate debated the tax code, individual senators came forward with rationales for all of the major deductions. The “powers that be” were exercising their prerogatives to continue their respective benefits, which Reagan’s vision for change would put at risk. Business practitioners anxiously pointing to the political uncertainty of a revised tax code were in retrospect overreacting, and thus putting too much emphasis on the uncertainty itself.

In 2008, Barak Obama campaigned under the slogan of “real change.” After his election, political risk analysts were doubtlessly impressed with the sheer uncertainty latent in the very notion of real change. Yet when Congress was considering the Affordable Care Act, Obama dropped his proposal for a public option, which would be useful should private insurers leave the planned exchanges. The president gave into pressure from the insurance industry lobby, the members of which stood to lose benefits should Obama’s healthcare plan instantiate real change even just in terms of there being a public health-insurance option. The resulting law was incremental because the private health-insurance companies were still to be relied on. The anticipated uncertainty regarding the American health insurance system turned out to be much less. The analyses of CEO’s making strategic decisions based in part on avoiding the American context due to the uncertainty would have been distorted, and thus not optimal.

In 2016, when Donald Trump was elected president, the uncertainty in terms of political risk must have been palpable in corporate boardrooms. Trump’s proposal of a substantial tax, or tariff, on American companies that take advantage of lower labor-cost countries and import the resulting products back into the large U.S. domestic market undoubtedly stocked the uncertainty without much thinking-through of how political compromise could take its toll on the proposal as it moves through Congress. Similarly, fears of trade wars resulting from the proposed tariff may have been overblown. That American companies would be subject to the penalty means that foreign companies manufacturing outside of the U.S. and importing into the large domestic market would have a competitive advantage. Pressure from Chinese companies could mitigate the likelihood of a Chinese-stoked trade war even though the pulling out of American companies (i.e., the loss of some manufacturing plants) would have a detrimental impact on the Chinese economy. Of course, such a scenario assumes that the actual tariff is enough to motivate American CEO’s to return their manufacturing to America; the political compromise that may be needed to pass such a tariff might reduce it to an insufficient level and thus effectively discredit the very idea of using public policy to alter the financial calculus of American companies such that they have a financial incentive to return voluntarily in line with maximizing profit.

The American preference for incremental over systemic change puts any genuinely new political proposal at risk of being shrunk to fit through the contours of the status quo, which is so dear to the vested interests. The uncertainty typically thought to exist in the advent of a new presidential administration tends to be overblown in retrospect. The American economy suffers from this bloated condition to the extent that CEO’s and corporate board directors move operations away from the geographically delimited hyper-uncertainty.

Global Markets and London Overreact to the British Vote to Secede from the E.U.: Missing the Bright Spots

The world’s financial sector may be excessively sensitive to increasing uncertainty associated with major changes—that is, changes that impact how large institutions, including governments, relate to each other. In such cases, so much is at stake that forces (i.e., the major powers) tend to manage the large-scale change with a minimum of disturbance. In short, the status quo has too much at stake for the market’s feared uncertainty to actualize. The British referendum on whether the E.U. state should secede is a case in point.

The full essay is at "Essays on the E.U. Political Economy," available at Amazon.

Political Protests in Hong Kong: The Market Overreacts

Geopolitical risk is essentially uncertainty to the market. Given the nature of human fear, the psyche can add a “multiplier effect” to an objective calculation of uncertainty. Just as we are naturally so close to human nature that its most ubiquitous tendencies eclipse our notice, so too do we tend to assume that the market’s assessment of a political risk is accurate, given the efficiency and effectiveness of the stock market. The market’s initial reaction to the political protests in Hong Kong in September 2014 may demonstrate that the market’s participants even routinely overstate both the probability and severity of the downside of a mass political event.

Under China’s “one country, two systems” accommodation of Hong Kong’s free market and democratic past, the semi-autonomous nature of the former British colony was presumably at risk as young adults protested Beijing’s decision to have a panel select three candidates to run for chief executive of Hong Kong in 2017. When the British returned the colony to China in 1997, the Chinese Government had promised that the post would again be elected democratically. To the protesters in 2014, the empty promise was a betrayal that could be read as a baleful sign of what life would be like under the rule of Beijing.

As though a knee-jerk reaction to the sight of large crowds taking to the streets in Hong Kong, stocks of companies having significant operations in or through Hong Kong lost value on the New York Stock Exchange on September 29, 2014. Iao Kun, for example, lost 6 percent, while Exceed lost 3.6%, Bonso Electronics lost 3.1%, and Global-Tech Adv. Lost 3 percent.[1] “Markets are jittery because anything that threatens Hong Kong’s status as a one country, two systems place could (affect) the world economy,” said Rod Smyth, chief investment strategist at Riverfront Investment Group.[2] I’m not convinced by this reasoning.

Firstly, Chinese communism had already come to embrace the government-influenced “free” market, so it does not follow that squashing the political protest would imperil firms in Hong Kong; it is not as if the private property would be grabbed by the government. Secondly, Beijing had a strong economic incentive at the time not to compromise Hong Kong as an economic engine. Ignoring this point, investors in the New York stock market overlooked the ability of Chinese officials to put down the protest without necessarily touching businesses in Hong Kong. That Beijing had the strange (to Western ears) fear that Hong Kong’s political freedoms would “infect” the rest of China does not translate into a fear that Hong Kong’s wealth might also “infect” other cities—as if too thriving cities would be a bad thing.[3]

Smyth claims the big “risk is this thing [i.e., the protest] escalates and China starts to get mad at protesters and comes in with a heavy hand and changes other things.”[4] The vagueness in this residual is itself an invitation for investors and stock analysts to extrapolate imprudently—which is to say, without much of an innate sense of the threshold beyond which lies blind fear tripping over itself ad infinitum. What things exactly? This question invites an orgy of uncertainty. Even if Hong Kong were to lose its semiautonomous status in China, it does not follow that Beijing would turn the city upside down. Rather, the objectionable political protests would likely result in modest political-only changes—keeping in mind China’s stake in Hong Kong’s role in the global economy. After all, even as semi-autonomous, Hong Kong cannot elect its chief executive freely. How much autonomy did Hong Kong have in 2014 that it would lose? The market’s initial reaction is not based on business fundamentals, but, rather, on irrational uncertainty.

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[1] Adam Shell and Kim Hjelmgaard, “Hong Kong Protests Buffet Markets,” USA Today, September 30, 2014.

[2] Ibid.

[3] Calum MacLeod, “’Umbrella Revolution’ Opens Wide,” USA Today, September 30, 2014.

[4] Shell and Hjelmgaard, “Hong Kong Protests.”