The global political stage will remain firmly in the spotlight this year. But it’s not just the Trump administration dominating the news flow: emerging markets face a raft of tight and unpredictable elections in the next 12 months. Here we assess how the political agenda in emerging markets will impact investors.
"We must be honest enough to admit the depth of the political, economic and social challenges our country faces. And we must be courageous enough to recognise the domestic and global conditions that give rise to these challenges1."
So said Cyril Ramaphosa during the African National Congress (ANC) leadership campaign. His long-awaited victory as party leader in late December gives South Africa a much-needed second chance. Nelson Mandela first nominated Ramaphosa as his successor in 1999 but was overruled by the ANC party. Almost 20 years later, Ramaphosa is now at the helm and offers the country the prospect of far-reaching reform.
Under his predecessor, President Jacob Zuma, South Africa has been dangerously close to state failure. Since Ramaphosa’s win political momentum has turned against Zuma. On Friday night, the ANC’s national executive committee decided that Zuma must leave office but did not set a deadline for his exit2. It follows Ramaphosa’s pledge to stamp out corruption which has long plagued the ANC party and restore investor confidence3. Nevertheless, progress is going to be slow. Ramaphosa now faces the daunting challenge of raising South Africa’s economic growth, tackling high unemployment and failings in the education system.
South African markets cheered Ramaphosa’s victory. And although the political stage is not the market, it can influence sentiment and policies can affect industries.
Looking back: politics impact emerging markets
History suggests that political upheaval can impact emerging markets. In Mexico, financial crises in the 1970s, 1980s and 1990s all coincided with elections4. For example, a month after President Ernesto Zedillo took office in December 1994, a peso devaluation drove the economy into crisis5. Undoubtedly, a plethora of factors contributed to Mexico’s financial crisis, but two of the main drivers were tighter monetary policy in the US and political instability.
In Argentina, after spending the early 1990s cultivating foreign investment, contagion from financial crises in East Asia and Russia prompted investors to withdraw capital from the country by 2001. The currency peg became untenable, and the government, unable to print money, borrowed it instead. President Fernando de la Rúa resigned on 20 December 2001, and five presidents took the helm in just two weeks amid widespread riots6. By the end of the year, the country defaulted on its $155bn public debt.
Last month, markets welcomed billionaire Sebastian Piñera’s win in the second round of the Chilean presidential election and the victory of the Bharatiya Janata Party in the state of Gujarat, which saw Indian Prime Minister Narendra Modi’s party claim a sixth consecutive term in in his home state.
Meanwhile, market reactions to political events can be unpredictable, as evidenced from Lula da Silva’s Brazilian presidential victory in 2002. The prospect of a win by leftist candidate Lula da Silva unnerved markets in the final weeks of the election campaign. However, following attempts to assuage investors’ fears, the real rallied by almost 4% and the risk premium on the country’s bonds dropped in the month that followed the election result.
Going to the polls
More important elections are yet to come, here are some of those investors should pay attention to in emerging markets the next 12 months:
Election outlook: risk and opportunity
Our investment teams are preparing for an uncertain political landscape in the coming months. Here they dissect political risk in emerging markets:
Ramaphosa’s victory in the ANC leadership race late last month offers South Africa a shot at real reform. The market moved quickly to discount a Ramaphosa government in the immediate aftermath of his ANC leadership victory, as it is expected that under his leadership investment should pick up, along with sentiment, and bond yields should drop further. However, the market has since surrendered some of those initial gains. Despite his victory, life in South Africa will remain difficult, as the transition to a middle-income economy is daunting, and social discord remains high.
In Russia, Putin will win the presidential election. The struggle for succession in the mid-2020s has already begun, but it is too soon for the market to discount a likely outcome. Meanwhile, in Columbia, the FARC will join the government, which is a good thing in some ways as an important section of the electorate will now be part of the political process. But it will herald the arrival of a radical leftist party in the Congress.
Elections in Mexico could herald a big change in policy. As such, there is cause for concern. The market is well aware of the risk of a MORENA government but is thus far unwilling to discount it. We are underweight at this point, waiting for a cheaper entry point that discounts the potential problems.
In Brazil, the election is also important, and the market is ignoring it. All Brazilians are hyper-aware of the issues: Lula da Silva – who might be allowed to run again – is leading the polls and Jair Bolsonaro, a far-right ex-general, is second in the polls. If Lula da Silva is allowed to run and subsequently wins the elections, he would effectively put an end to the current economic reform agenda, which is essential for the country’s continued economic recovery. In particular, the pension reform is integral to capping Brazil’s debt trajectory and it seems the current administration may struggle to win approval before the elections, meaning the new administration will either promote or kill it. However, given the recent strong stock market performance in Brazil, investors appear to be betting against a Lula victory. Many Brazilians believe a centrist candidate will emerge in the race for leadership and win the election.
Meanwhile, the return to democracy in Thailand could mean a resumption of federal spending, which could kick-start the country’s growth cycle. Investors may decide to return to the market, but the strong baht is harming exporters.
There are several political events that credit investors need to navigate in emerging markets this year, with Mexico and Brazil providing particular challenges. That said, in an ever-globalising corporate world, it is important to recognise two key points. First, country-specific risk and its effect on currencies, interest rates and spread premia transcends the invisible boundaries between emerging and developed markets. Second, the location of a company’s headquarters often does not inform an investor of the diversity of its exposures and end-operations geographically.
These key points provide both opportunities and threats to a global credit investor. We continue to see opportunity in export-related businesses across Russia and Latin America. For example, in Russia we like Norilsk Nickel, one of our holdings, thanks to its low-cost profile, long reserve life, diversification by product line and exposure to positive demand growth for nickel owing to rising demand for electric vehicles. Meanwhile, in Latin America, we favour low-cost iron ore producer Vale, a holding in our portfolio, as it is benefitting from a low-oil-production environment and increased Chinese demand for higher quality iron ore. At the same time, the company is increasing low-cost production, reducing debt and improving its environmental, social and governance profile by consolidating share classes and listing on Novo Mercado, a segment of the national stock exchange with stricter governance requirements.
Conversely, we think there is a need to price risk appropriately for exposure to emerging-market risk. We are cautious towards companies that are heavily exposed to such risk, but whose instruments trade at prices that do not reflect this as the companies are headquartered in developed markets.
Assessing the impact of political risk on an investment portfolio is notoriously difficult. By its very nature, the influence of politics on markets can be sudden, representing a step change which can be hard to quantify: many traditional risk models fail entirely to capture these events. Modelling the impact of elections on a local market index is complex, and factoring in the impact on overseas companies with exposure through their supply chains or customer bases requires a sophisticated, data-driven approach.
Recognising these challenges, we use our proprietary risk system, MultiFRAME, to provide insight into the potential impact of political upheaval. MultiFRAME was built in 2008 following the financial crisis as the Hermes Global Equities team sought to address the weaknesses of traditional, commercially available risk models. The flexibility of MultiFRAME allows us – and other teams within Hermes – to measure their portfolio’s sensitivity to any quantifiable risk, while also calibrating the model using any period of history to provide in-depth scenario analysis.
This flexibility is key when trying to understand how a portfolio is exposed to political risk. By measuring exposure to a country’s currency or to its bond default spread (relative to US Treasuries, for example) an investor can understand the portfolio’s sensitivity to the market’s perceived risk of the country. By evaluating a portfolio’s risk over a range of historical time periods, the impact of different regimes can be estimated. And by comparing risk models of different durations (a short-term model versus a medium-term model, for example), the market’s expectations of how risk is evolving can be gauged.
Looking beyond the traditional methods for assessing risk is crucial to generating sustainable risk-adjusted returns. The drivers of risk change over time, and a flexible system such as MultiFRAME provides managers with the ability to truly understand the market. Of course, we also recognise the limitations of any such model and supplement this with disciplined fundamental analysis. The rise of big data is improving the effectiveness of this analysis, with quantitative data now providing in-depth supplier and customer relationship maps as well as more granular breakdowns of revenue by geography – the latter has proven especially effective as we try to diversify our portfolio’s risk budget to limit the impact of geopolitical volatility.
Elections can be a significant source of disruption for emerging markets, which are typically highly exposed to political risk.
The recent revival of populism at a global scale poses significant challenges in Latin America, a region which has been accustomed to the phenomenon for decades. A populist government would probably lead to looser fiscal policies, a rebuttal of much-needed structural reforms and a higher country risk premium. Also, it could result in a rise in protectionist policies and reduced trade flows throughout the region. In Mexico, the risk of populism gaining traction at the next general election in July seems high as growth has been sluggish, negative sentiment towards the establishment is rising, and the relationship with the US is being strained under the Trump administration.
While the overall outlook for emerging markets next year is constructive, it is necessary for investors to take into account political risk – both in terms of underlying recurring themes and idiosyncratic situations – as they navigate markets in the quest for investment opportunities.
Bracing for political change
From Bogotá to Bangkok, emerging markets are poised to swing to the prevailing political winds in the coming months. At Hermes, our investment teams are cognisant of the risks and opportunities political change can afford and assessing them is essential to generating sustainable risk-adjusted returns.
Political risk matters across all asset classes in emerging markets. Many investors will hope for a measured market reaction to the forthcoming elections in emerging markets, but political upheaval by its nature presents both investment risks and opportunities – and for investors, bracing for this change is key.
The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.
When considering an investment you should ensure that you read the offering documents before investing which will include a comprehensive list of the risks associated with the product. It should be noted that any investments overseas may be affected by currency exchange rates. Investments in emerging markets tend to be more volatile than those in mature markets and the value of an investment can move sharply down or up. Past performance is not a reliable indicator of future results and targets are not guaranteed.
1 “Ramaphosa’s speech on radical economic transformation,” published by Huffington Post as at April 2017
2 "Pressure mounts on Zuma to quit as South African President," published by Bloomberg as at January 2018
3 “Cyril Ramaphosa wins ANC leadership race dealing blow to Zuma,” published by the Financial Times as at December 2017
4 “Half emerging-market bond index faces election risk in 2018,” published by Bloomberg as at November 2017
5 "Mexico: The slippery road to stability," published by The Brookings Review as at March 1996
6 “Argentina's turbulent history of economic crises," published by Reuters as at July 2014
7 “Vladimir Putin announces he will seek re-election in 2018” published by Financial Times as at December 2017
8 “Russia’s economy is growing with borrowed money,” published by Bloomberg as at November 2017
9 “Farc eyes Colombia’s 2018 elections as it seeks new political dawn,” published by The Guardian as at September 2017
10 “Jokowi heads to 2018 with backing of stronger Indonesian economy,” published by Bloomberg as at December 2017
11 “Mexico economy shrinks for first time in nearly two years,” published by Reuters as at November 2017
12 “Everything you need to know about Malaysia’s upcoming election,” published by Bloomberg as at December 2017
13 “Brazil’s Lula plots comeback despite corruption conviction," published by the Financial Times as at January 2018
14 “Thailand says it’s on track to end military rule in 2018,” published by Bloomberg as at November 2017
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