History shows emerging markets can't ignore politics much longer

London - Emerging market investors may have become too complacent about political risk.

Stocks, bonds and currencies of developing nations have soared over the past 21 months, despite tremors on the global landscape from Brexit to Donald Trump’s US presidency, not to mention coups and impeachments in their own backyards.

Emerging assets are trading at or near record highs relative to a gauge of their political risk, according to data compiled by Bloomberg. There’s a similar trend for inflows into exchange-traded funds.

But if history is a guide, gains and losses in developing markets are influenced by domestic stability levels in the long run. So when the US Federal Reserve closes the tap of easy money and starts chipping away at the appeal of riskier assets, investors are likely to think twice about buying into markets and funds that could get swept up in a contagion selloff.

Some money managers are already factoring that in, becoming increasingly selective about which developing nations to place their wagers on, instead of betting on the asset class as a whole, according to Claudio Irigoyen, a New York-based Bank of America Merrill Lynch strategist who has been discussing the topic with clients.

Investors are more focused than ever on diversifying across countries, and domestic issues are their top short-term concern, he wrote.

Risks overstated

Yet the predominant mood in the market is that political risks are often exaggerated. Sean Newman, an Atlanta-based senior money manager who helps oversee $908bn at Invesco, says that while the potential for one-off events upending individual markets can’t be discounted, they won’t have a widespread impact on emerging assets as a whole.

“It’s not that political risk isn’t relevant,” said  Charles Robertson, Renaissance Capital’s London-based global chief economist. “It’s just that it shouldn’t be overstated.” Unless there’s a negative impact on economic growth, then markets won’t suffer as much as some fear, he said.

Still, a flurry of idiosyncratic uncertainties are coming together to make the next 12 months potentially turbulent for emerging markets.

South Africa faces a potential downgrade of its local-currency credit rating as infighting in the ruling party threatens to leave the government in limbo Turkey has been embroiled in diplomatic rows with the US and Germany.

According to a poll in Brazil, market favourites are lagging behind rivals in the run-up to next year’s presidential elections.

In Mexico, the chances Andres Manuel Lopez Obrador may become the nation’s next president has sent the implied volatility on the peso soaring because he opposes efforts to open the economy and promises to boost social-welfare spending. The Trump administration has also adopted an aggressive stance on free-trade talks with the Latin American nation

Each of these events risks turning the tide against emerging markets, according to Pacific Investment Management.

“All political events are worth scrutiny as they can signal both a change of a country’s trajectory, as well as risk a spike in pre-election spending,” said Yacov Arnopolin, a London-based money manager at Pimco.

Emerging-market stocks traded near a six-year high and currencies rose for a fourth day on Thursday.

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