An emerging market toolkit is essential for investors in the West
Economic nationalism has led to a boom in political risk analysis.
During the financial crisis I found that mugging up on economic history, particularly from emerging markets, was often more helpful than talking to conventional policymakers hooked on their fair-weather economic models.
The rise of economic nationalism and the threat to globalisation means I find myself using emerging market parallels again. I cannot help wondering if investing in Western markets may become more like investing in emerging markets.
Investing in emerging markets requires an intense focus on country risks and political economy. Investors in the West have long been able to ignore political risk and focus on the sectors’ or individual companies’ prospects. But the prospect of a new independence referendum in Scotland is only the latest in a series of shocks to the institutional fabric of Western countries.
Careful monitoring of the strength of political institutions and corporate governance issues are central to successful emerging market investing and can have a profound impact on valuations and long-term growth expectations. Our analysis suggests country risk can account for as much as half of investors’ returns. Little wonder the market for political risk analysis is booming. Since the crisis some domestic sectors have already been severely affected by this – the epicentre being banks. US banks are up 51% in the last 12 months, whilst British banks have fallen 21% for international investors.
Emerging markets also teach us that economic nationalism is often inflationary. In the West, after an excessive reliance on monetary policy, a reflationary regime-change in trade, fiscal and regulatory policies is welcome. But emerging markets’ experience suggests we should watch carefully how this plays out. In the early stages of programmes, the reactivation of the economy is often positive as employment increases. But emerging markets diverge later on. Some succeed strongly. For others, weak investment and poor productivity often follow, and the interaction of a rise in inflation and inequality can feed the politics of anger, particularly in those markets where income levels are lower.
Currency volatility is also higher under economic nationalists. For investors this type of volatility in Western markets could be a fundamental change in the way we think about risks across portfolios. However, I suspect that the reserve currency status of the Western economies taken by economic nationalism should be a drag anchor to avoid the excessive currency volatility and spikes in the cost of financing, absent a eurozone breakup.
Emerging markets also show us populism is infectious. Across Europe, populist parties could have a material impact on the elections in Holland, France and Italy. The feedback loop from the US and UK elections upon the narrative of European elections is also strong.
Populists typically have also put far more political pressure on their institutional fabric. Although we have seen growing challenges, not least to central banks’ independence, we assume the strength of Western institutions will win out. But this pathway doesn’t need to be negative. The threat of protectionism may prompt a stronger policy response to boost domestic growth – which Europe sorely needs.
Economic nationalism is also about an inflection in regulatory policies as the benefits of globalisation continue to be reappraised. The Balkanisation of banking markets will grow as countries put up financial walls and the consensus around Basel banking rules breaks down.
The US is likely to have an economic boost from the filing down of the rough edges of banking rules to enable credit to flow more easily. Whilst a more compartmentalised banking system can help seal off shocks, it is likely to be negative for growth unless global markets can fill the gap, as we also find in emerging markets. The negative tone towards capital markets from some European nations as the UK leaves the EU concerns me and could be a brake on their economic growth.
But historical parallels can only take us so far. Underlying shifts in technology, impacting work, culture and politics sits in the middle of a Venn diagram and intersects with economic nationalism, political nativism and the fragmentation of globalisation. Since this technological change is here to stay and accelerating rapidly, the impact will keep growing.
A fundamental destabilisation of markets and economies is the consequence of these changes. A different distribution of economic and financial returns is the result.
A guiding principle for investors over the last 30 years has been convergence - whether it be emerging markets catching up with developed, or eastern and southern European economies converging on western Europe. Quantitative easing has helped suppress divergence, but can no longer be taken for granted. If we are investing in a more divergent world, then the emerging market toolkit, alongside a deep understanding of how technology is impacting societies, business and markets, will be critical.
Johanna Kyrklund, Global Head of Multi-Asset Investments and Nicholas Field, Global Emerging Market Equity Strategist, also contributed to this article
This is a slightly expanded version of an article which first appeared in the Financial Times on Wednesday 15 March 2017.