UK markets – is there a political risk premium?

Charles Younes

Charles Younes

For the last 10 years, UK markets have been immune to political risk.

The debt crisis affecting numerous eurozone countries forced investors to turn their attention to this side of the channel, with the UK appearing as a safer option. At that time, foreign investors did not claim a country risk premium (CRP) to invest. 

CRP is the additional risk associated with investing in an international company rather than the domestic market.

Macroeconomic factors such as political instability, volatile exchange rates and economic turmoil causes investors to be wary of overseas investment opportunities, thus requiring a premium for investing.

It is fair to state that following the EU referendum vote in 2016 and the UK general election in June 2017, investors have moved away from the UK to re-invest in the eurozone. But is there really a risk premium to invest in the UK markets? 

Because this premium value is mainly driven by foreign investors, the analysis of currency movements is the best way to assess it.

Unsurprisingly, the CRP, as measured by the 12-months volatility of the pound sterling against its two main trading partners, the euro and the US dollar, peaked from June 2016 to June 2017.

Since then, the volatility has dropped under 10 per cent, as the recent turmoil within Theresa May's government has left the currency markets unchanged. The current number corresponds to the levels reached in the beginning of 2013. 

The eurozone debt crises has also led to the rise of credit default swaps (CDS).

A CDS is a swap designed to transfer the credit exposure of fixed income products between two or more parties. The seller agrees that in the event that the debt issuer defaults, it will pay the buyer the security’s premium as well as all interest payments that would have been paid between that time and the bond’s maturity date.

A credit default swap is, in effect, an insurance against non-payment. 

The change in CDS prices of UK government bonds helps assess the CRP. The CDS price jumped in June 2016 (the EU referendum vote) from 15 to 30, indicating that holders of UK gilts were keen on paying a higher price for hedging the default risk on UK gilts. It is currently trading at 23.8, which is below the five-year average.

Nevertheless, it remains more expensive to hedge the default risk for UK gilts than German bunds, indicating that the political risk has shifted from the continent to the UK. 

Finally, equity markets can also give us a final estimation of the CRP.

We can do so by looking at the performance of domestically-focused companies relative to the FTSE All Share index.