Q: I read on social media that investors are pulling out their funds from the market because of President Duterte’s outbursts. How does this affect the market?—Jonathan D, by e-mail
There may be a lot of political noise now, but it doesn’t necessarily mean that it directly affects the stock market.
Share prices move based on expectations. Investors buy stocks on the assumption that over the long term, share prices will appreciate as business expands and earnings increase.
When there are uncertainties that threaten market expectations, investors tend to demand a higher return on capital to cover additional risks. A higher rate of return means lower market valuation, which leads to lower share prices. The increase in the rate of return as a result of uncertainties is what we call the equity risk premium.
This equity risk premium has three components. The first component is the political risk, which arises from uncertainties resulting from purely political issues. For example, worsening graft and corruption in government or deteriorating peace and order situation.
The second component is the impact risk, which arises from uncertainties resulting from changes in government policies that can impact business profitability. For example, increasing taxes or introducing new laws to nationalize certain industries.
The third component is the capital risk, which arises from non-government induced uncertainties that affect the economy and business sector. For example, falling crude oil prices or the slowdown of the Chinese economy.
These three components often interact with each other and reflect market sentiment.
Given the political headlines that we see in media, it will be easy to conclude that it is political risk that is affecting market sentiment.
While there are valid reasons to be concerned about the perceived unpredictability of President Duterte, the recent fall in the market could not be entirely blamed on the President. Many investors may be disappointed by the President’s recent controversial pronouncements, but a prolonged weakness in the market could not be driven only by perceived political risks.
There must be other components in the risk premium that are leading the charge. Capital risks, for example, show that there are fears of rising rates in the US, causing foreign investors to cash out of the market to safe havens. Many believe that early indications of a stronger US economy may prompt the Fed to increase interest rates in November.
This uncertainty coupled with threats of rising political risks has given investors compelling reason to take profits on an already expensive Philippine market, which has an average 22x P/E compared to emerging markets’ average of 16x P/E.
When a market trades above its historical average P/E, the possibility of a further upside becomes limited.
When that happens, the market falls into correction.
Historically, political risk tends to be a larger component of the risk premium when the economy is weak.
But the Philippine economy is now stronger.
When times are good, political risk tends to be a smaller component of the risk premium. Investors put more weight on uncertainties that have direct impact on economic fundamentals. When economic conditions are good, risk premium is driven more by capital and impact risks than political. It is possible that with the prospect of rising capital risks in the market, the PSE index may fall toward 7,000 once it breaks its support at 7,500.
Not everything you read about politics affects the stock market. And when there is risk, there is also opportunity.
Henry Ong is registered financial planner of RFP Philippines. Learn more about market outlook under Duterte Administration at the 5th Financial Advisors Congress on Oct. 15 SMX Aura. To register, e-mail info@rfp.ph or text <name><e-mail> <FAC> at 0917-9689774.