In the midst of one of the most turbulent weeks on record in global markets, Merrill Lynch on Wednesday became the latest in a series of bulge bracket firms to announce its plans for expansion in emerging markets, following in the footsteps of many of its peers – including Citigroup and HSBC - who are shifting gears to up profit targets from these much-touted new drivers of global growth.
Merrill’s new boss, John Thain, at least qualified the approach by pointing out that while “no one is immune from the global slowdown” emerging markets such as Russia are “probably more insulated” than other developing regions.
In this, he is probably right. But while deepening anxiety about global economic prospects casts its shadow over the market, what’s being increasingly ignored is the return of political risk.
Risk - of debt default, civil war, coups or simply poor policy-making - was always part of the bargain when buying into emerging markets. But the past decade has also seen a steady decline in the premium investors demand to hold assets from less-developed, and thus riskier, countries.
It’s a truism now that the benign economic climate of recent years has bred complacency in the market. At the same time, it has become increasingly fashionable for investors to dismiss the possible financial impact of political events in these countries as a throwback to a bygone era when instability in east Asia could stall markets in Latin America. Coup in Thailand? Bring it on.
This attitude is folly. With money tighter, the global economy slowing and many emerging assets more expensive than ever, politics is bound to have a greater effect. Moreover, government stability in key emerging markets – including Russia, China and India – could falter, perhaps significantly, if the rate of global economic growth drops sharply.
Many rightly point out that from a credit and cash-flow position, emerging markets have substantially improved from where they were a decade ago. And indeed, political risk premia tend to fall in periods of ample liquidity. But the converse is also true.
Yet even in the wake of recent violence in Kenya and Pakistan, analysts are by and large delivering a hopeful spin, pointing out that the medium-term outlook for frontier investing remains solid, so long as investors can correctly differentiate the good credits from the bad.
But the fact is that instability is rife, and arguably most acute in petro states – Iraq, Iran, Venezuela, Nigeria and Saudi Arabia – not to mention the wider middle east. Then there’s Asia, where political risk is not just confined to escalating violence in Pakistan. Myanmar, Malaysia, Bangladesh, Nepal and Sri Lanka have also recently witnessed political tensions. Moreover, there’s continued uncertainty over government stability in Japan and Thailand, while U.S.-North Korea and U.S.-China relations remain fraught.
It’s not just political instability that’s at issue. Economic nationalism too has made a startling comeback over the past five years. 1970s-style expropriation has returned, most explicitly in Venezuela, which has announced plans to nationalise telecommunications, electricity and oil businesses. Meanwhile the risk of forced state take-overs has also grown in countries like Russia, Ecuador, and Chad, among others.
Moreover, with global banks turning to sovereign funds, growing suspicion about world trade and protectionism on the rise in the U.S., Europe and elsewhere, the role of politics has hardly receded. Today’s stress in financial markets makes far-reaching risk assessment all the more urgent.
How good are we at pricing in and preparing to counter risks – including low-probability high-cost events? If history is any guide, not very. But what’s clear is that current and future political developments will have direct implications for the stock markets, bond spreads, currencies and capital inflows of these economies.
With global economic conditions in decline, the risks that had retreated into the shadows over the past decade are poised for a nasty comeback: tread with care when weighing up emerging market prospects - this year and beyond.