Politics and your portfolio: how an unpredictable year affected developed and emerging markets
Investors should always be aware of political risk. In 2022 we’ve seen mature markets shocked by the Ukraine invasion and the US/China trade war. Conversely politics in some developing countries have had less impact than may have been expected.
IN A FEW WORDS
Political riskDeveloped marketsEmerging marketsLatin American economyPolitics in developing countries
6 min reading
At times of global co-operation and benign geopolitics, investors may forget that political risk can affect their returns. From Russia to China, the US and, more recently, the UK, this year has provided plenty of unwelcome reminders that political risk still exists.
Early in 2022, experienced fund managers were wrong-footed by Russia’s invasion of Ukraine
Many had considered it safe to invest in Russia, with Putin having little ambition for a global power-grab. That proved optimistic, with Russia’s invasion of Ukraine forcing many to write down the value of their holdings. BlackRock, for example, took at $17bn hit on its holding in Russian securities.
Political tensions with the US have had real financial consequences for Chinese companies
China has also been problematic. Tensions had been rising with the US for several years, culminating in a full-blown trade war during the Trump administration. This has had ongoing financial market implications, and some investors have seen significant losses on China portfolios in 2022.
This could get worse. Chinese stocks could be delisted from the New York Stock Exchange in 2024, depending on whether they can come to an agreement with regulators. This would see them lose a powerful source of funding. At the same time, trade barriers erected between the two countries mean Chinese goods can no longer trade freely in the US and China no longer has unfettered access to US technological know-how. In 2019, the President Donald Trump issued an executive order banning the use of telecommunications equipment from those foreign firms deemed a national-security risk. Chinese telecoms companies such as Huawei have seen their revenues decline significantly as a result.
As political tensions have risen, China has seen international fund flows dry up. Capital outflows from China are now running at their highest level ever. The Institute of International Finance says non-Chinese investors have pulled $2.2bn out of Chinese stock portfolios since the start of the year.
The UK has been another source of political risk in recent years
The decision to leave the European Union dented confidence in UK assets, from which it has never quite recovered. More recently, an ill-judged fiscal experiment from short-term Prime Minister Liz Truss, which sought to bypass the checks and balances of the Office for Budgetary Responsibility, showed how quickly confidence in a country can evaporate.
While the additional borrowing proposed under Truss was not vast by international standards, the administration’s approach spooked markets and exposed the fragile confidence on which UK government borrowing lay. The markets decided the UK was a worse credit risk than it had previously thought and demanded a higher interest rate to lend it money. 30-year gilt yields jumped around 1.4% percentage points in the immediate aftermath of the budget, taking them from 3.5% to 4.9%. The Bank of England was forced to step in to prevent instability in the pension fund market and the Truss experiment was, ultimately, consigned to history.
The situation is more positive for some emerging markets
The Latin American financial markets used to command a political risk premium given their history of wayward governments and economic mismanagement. However, this reputation has looked increasingly ill-founded of late as these countries have given their central banks independence, appointed sensible finance ministers and got to grips with inflation.
The Latin American economy was put to the test in 2021 and 2022 with elections in Brazil, Columbia, Peru and a constitutional referendum in Chile. While there has been plenty of rhetoric in the election campaigns and a swing to the left across the region, economic management has generally been strong. The recent Brazilian elections saw none of the turmoil of the US 2020 presidential election and 2022 mid-terms, in spite of fears that Bolsonaro would not accept defeat. It showed the growing strength of institutions in the region.
In general, political risk is far more of an issue in bond and currency markets than in equity markets
Brazil and other emerging market economies have recognised what Liz Truss did not, that market confidence is vital for a country’s borrowing costs. Countries deemed at risk of political instability will see it reflected in higher bond yields and a weaker currency. This is why emerging market debt tends to have a higher yield than developed market debt, though there is an argument that many emerging market governments have a more prudent approach to debt than many developed markets.
There is likely to be less impact from political risk in equity markets. Companies often generate their revenues from across the globe and where they choose to list will have little impact on their profitability. The FTSE 100 is a good example. Many of the UK’s largest companies draw their revenues from across the world and have benefitted from the strength of the Dollar, as they are converting their revenues into Sterling.
It can be a problem if there are companies with significant state ownership, where there may be a tendency for the government to interfere in the running of the company, or – in more egregious cases – appropriate assets. Argentina, for example, received a lot of criticism over its nationalisation of oil company YPF. Many of China’s technology giants saw a significant sell-off as the government launched a crackdown on the use of data and instituted new anti-trust rules.
Political risk is increasing as the world looks set to de-globalise
The US, for example, looks as politically unstable as it has for decades. More than ever, it is worth keeping an eye on political risk in your investment decision-making.
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