Emerging Markets: Will strong 2017 give way to global headwinds?

January 16, 2018 08:02 AM

Global markets have been on a tear, hitting fresh highs supported by low rates and synchronized global growth. Emerging markets have benefitted from record inflows to rise strongly this year, but political risk seems to be rising even as volatility is falling (see “Emerging markets soar,” below). 

While crackdowns and shakeups hit the headlines, not all of these are negative for the potential of these markets and can, in some cases, increase returns in the long term.

The emerging markets classification covers a huge range of countries at different levels of development and under a variety of governance regimes, from democracies to autocracies. The most popular benchmark used to judge emerging market performance and its investment universe is the MSCI Emerging Markets Index (EEM), which comprises 23 global markets from Pakistan to China. Dedicated fund managers now have decades of experience in investing in stocks in these countries, which can deliver many times your investment in a year like this, or see a rapid evaporation of capital if you get caught in a Russian debt crisis.

The main advantage that foreign investors have when investing in the stock markets of these nations is the ability to invest ahead of the herd in stocks that have strong fundamentals, which local investors may not pick up on, and provide patient capital to weather any potential volatility. 

This is a key reason why, against a backdrop of growth superior to that of developed markets and secular drivers like increased smartphone penetration and an emerging middle class, a successful strategy is to follow Baron Rothschild’s aphorism that “the time to buy is when there’s blood in the streets,” seeing through panics to invest for the long-term.

Some of the largest panics can come when there are sudden changes in the government or social contract of a country, for example during coups or periods of dramatic reform.

Coups usually occur when there is considerable strain on a social contract between a government and its people, creating a weakness that another power bloc can take advantage of, leading to a change in leadership. As such, they are often popular in the short term, particularly as the military who tends to undertake them are usually in an exalted position in many emerging market economies.

Real reforms, by definition, challenge the status quo and can be resisted by powerful parties who are typically in the business sphere, particularly when they are part of a crackdown on corruption. Corruption is rife around the world, but in developed countries it is usually codified and legal such as not tendering for military procurement contracts. In emerging markets, it tends to be a case of misaligned incentives, particularly in governments whose rule is through power and not consent as there are not sufficiently strong social institutions in place to balance out greed and avarice.

During these periods of stress and uncertainty, the situation can appear chaotic, causing shorter-term investors to sell down their assets and wait until the situation stabilizes. However, when there is rapid clarity, this can often be a huge boon to markets as it lowers the range of possible outcomes and the population can breathe a sigh of relief to get behind the government. 

Recent examples of this include the failed coup in Turkey, after which the market has risen 60% aided by government fiscal support and the 2013 coup in Egypt, after which the market rose 110% the following year despite an apparent move away from democracy.

Research by emerging markets consultancy Ecstrat shows that the best environment for corporate stock performance long term appears to be liberal governance regimes, such as in democracies, where private entrepreneurs can rely on the rule of law and flourish. Shorter term, investors typically prefer predictability and the ability to push countries along the economic development curve, even if this is typically not in a democratic format. 

These can be messy given election cycles, but under the leadership of a strong individual with a definite plan such as Lee Kuan Yew, Narendra Modi or Xi Jinping, such regimes suffice until civil institutions can be built.

The marginal change in the ability for corporates to operate and have predictability is also hugely important. In the case of Saudi Arabia, a previously consensus-based government that suffered from huge inertia and bureaucracy has been shaken up under new leadership that is now consolidated under the King and his son the Crown Prince, who have control over all branches of government and state-owned enterprises. 

This provides an extra level of predictability that is likely to support inflows into the country if they lay out clear new legislation against corruption and conflicts of interest, as well as independent courts to protect minorities, increasing foreign ownership from under 1% to the 30% and above we have seen in other Emerging Market nations.

When people are fed up with the status quo and their social contract with the government, we often see sharp changes that can be disconcerting. While volatility is at record lows, more turbulent waters may be ahead but these could well be opportunities rather than risks for investors who have the right investment horizon and flexibility to benefit.  

About the Author

Emad Mostaque is co-CIO of Capricorn Fund Manager, an emerging markets hedge fund based in London. @emostaque