The wave of startling political events have swept through emerging markets this year that are all the more disheartening as many have occurred in democracies that only a short time ago were former poster-boys of economic success.

The back-and-forth in Dilma Rousseff’s ongoing impeachment proceedings in Brazil has created huge uncertainty and coincided with what may become the country’s deepest ever recession. 

The election of Rodrigo Duterte as the Philippines 16th president was controversial to say the least, given his alleged links to violent vigilante groups, and South Africa is beset by corruption scandals.

But while the experience on the ground in the countries may be traumatic, sticking to the remit of this magazine, one must consider whether political risk real or illusory for the outlook of financial markets.

Emerging markets are certainly not alone in face distressed populaces – the Brexit referendum, the Trump phenomenon and a near victory for the far right in Austria are just a handful of examples. And, in any case, change, however unexpected and forceful, does not necessarily lead to bad outcomes.

Seen in CDS

Deutsche Bank Research points out that emerging market sovereign risk – as measured by the spreads on credit default swaps (CDS) – has markedly increased over the past 24 months. 

While this has a number of drivers, including a strengthening dollar and the prospect of US interest rate rises, investors are increasingly differentiating between countries and a key point of differentiation is political risk. For example, sovereign risk in Indonesia and Korea is at the same level it was 24 months ago, while in Brazil, CDS spreads have doubled.

Rising political risk impacts investors in a number of ways. The currency tends to take the first hit. The Brazilian, Turkish and South African currencies have all found themselves battered by political concerns over the past 12 months. When this happens the stock market is likely to soon follow; once sentiment goes against them they are also vulnerable to a liquidity squeeze.

Equally, markets ebb and flow on the perceived progress of structural reform as well as corporate governance improvements. For example, the Indian stock market saw a strong bounce on the election of Narendra Modi in anticipation that he would introduce significant political reform; its recent weakness is largely in response to his relative failure to deliver that reform.

This is both logical and borne out by evidence: research has shown that corporate governance and infrastructure improvements in emerging markets have a lasting effect on productivity. In a recent report on structural reforms and productivity growth the IMF stated: “A large body of empirical evidence finds that structural reforms can improve resource allocation and boost productive capacity. 

Potential sources of productivity growth in emerging markets arise from catch-up growth by absorbing technology and ideas from advanced economies, structural change into higher-productivity sectors and new activities, and improved resource allocation within sectors.

“Higher quality and quantity of infrastructure and human capital, trade openness, efficient and well-developed financial systems, and economic institutions that promote competition, facilitate entry and exit, and encourage entrepreneurship and innovation have been variously found to increase productivity growth at the cross-country, industry, and firm levels.”

Financial impact

The definition of what constitutes political risk in this context may not always be as expected. For example, as far as markets are concerned, Duterte is not quite the risk he might seem however uncomfortable commentators may be with his social policies. 

SooHai Lim, manager of the Baring ASEAN Frontiers fund, points out that he has been mayor of Davao City for 22 years, during which time he has tackled crime, improved the economy and built much-needed infrastructure. Lim adds: “While there has been some campaign rhetoric, he has proved his ability to deliver.” As such, markets have remained relatively unmoved by his election.

Even in Brazil, where political risk has weighed heavily on markets in recent years, the impeachment of Dilma Rouseff, to some, suggests a system that is working well. Ross Teverson, head of strategy, emerging markets equities at Jupiter, says it shows Brazil has a strong rule of law, and that checks and balances are functioning.

Nevertheless, there are markets where politics exercise considerable influence. Lim suggests Thailand: “It is a constitutional monarchy, and the king is not in good health. The transition from him to his heir is delicate and the country is still divided. The king is currently the unifying factor. The military are providing calm and stability, but it may only be temporary.” 

Marteen-Jan Bakkum, senior emerging markets strategist at NN IP also highlights South Africa, where President Jacob Zuma, has “lost all credibility” and where the ANC is losing support. He is also concerned about Turkey, where President Erdoğan’s “big plans” could potentially derail stability. Most recently, he denounced birth control for Muslims as un-Islamic, the latest in a long series of controversial pronouncements.

Most fund managers will not admit to putting political risk at the forefront of their analysis, preferring to consider themselves stock-pickers – politics only comes to the fore when it prevents the proper function of business.

So when does political risk become a problem? Ownership rights are particularly sensitive. Argentina was considered uninvestable for some time due to Cristina Fernández de Kirchner fondness for appropriating assets into state hands. In 2012, the government announced it would seize a majority stake in YPF, the nation’s largest oil company and majority-owned by Spanish energy company Repsol YPF.

Although Argentina has done much to put its house in order, most still consider Venezuela uninvestable. Teverson says: “Politics may impact the returns on stock markets in the short term, but strong corporate fundamentals should outweigh that over time. The only exception is when political drivers are so overwhelming that it is difficult for companies to escape.”

This means that he has maintained some holdings in Brazil throughout its recent problems. Equally, he has held a number of holdings in Nigeria, in spite of the political instability there: “We can still find individual companies even in difficult markets, where there is significant positive change.”

Valuations

The other consideration, of course, is price – there are times when political risk is fully priced into markets. Emerging markets have fallen a long way in recent years and valuations are not demanding. The Brazilian stock market, for example, at the start of this year was around 40% off its 2012 high (it since partially recovered when steps were taken to impeach Dilma Rouseff and the oil price started to stabilise).

Teverson says: “We take a view on whether the risk is priced into stocks and look for what might lead to a positive surprise in earnings. We observed a similar phenomenon in Russia after the Ukraine crisis. A lot of investors had decided it was uninvestable. This blanket assumption means that a number of opportunities were missed by investors. Some exporters, for example, benefited from the falling ruble.”

Political risk can present an opportunity but much will depend on the entry point. In India, reform momentum has stalled and this has been negative for markets because so much expectation had been built into stock market prices. 

In contrast, there is real reform potential in Indonesia, but this was not reflected in valuations. The situation in Thailand may not look fantastic, but the military junta has at least succeeded in bringing stability.

Political risk is more of a problem when there are other factors in play. Bakkum says that a red flag for them is when political risk is rising as global markets are falling. 

This happened in Brazil when the corrupt and ineffectual government was faced with a declining oil price and therefore a slide in its revenues. Markets are often willing to overlook problems and corruption when an economy is relatively buoyant, but will pay more attention as it weakens.

Political risk is increasing globally across all markets. This may represent an opportunity as much as a threat but will depend on circumstances. If governments start seizing assets from the corporate sector, or profound political turmoil threatens to derail a country’s currency, then investors will take notice. 

Equally, if it coincides with severe economic problems, political problems may have a greater impact. Politics matters, but not necessarily in the way it initially appears.