One
of the great mysteries of today’s global markets is their irrepressible
enthusiasm, even as the world around them appears on the verge of chaos
or collapse. And yet, investors may be more rational than they appear
when it comes to pricing in political risks. If investing is foremost
about discounting future cash flows, it’s important to focus precisely
on what will and will not affect those calculations. The potential
crises that may be most dramatic or violent are, ironically, the ones
that the market has the easiest time looking through.
Far more
dangerous are gradual shifts in international global institutions that
upend expectations about how key players will behave. Such shifts may
emerge only slowly, but they can fundamentally change the calculus for
pricing in risks and potential returns.
Today’s market is easy to
explain in terms of fundamental factors: earnings are growing, inflation
has been kept at bay, and the global economy appears to be experiencing
a broad, synchronised expansion. In October, the International Monetary
Fund updated its global outlook to predict that only a handful of small
countries will suffer a recession next year. And while the major
central banks are planning, or have already begun, to tighten monetary
policy, interest rates will remain low for now.
Political crises,
however sensational they may be, are not likely to change investors’
economic calculus. Even after the greatest calamities of the 20th
century, markets bounced back fairly quickly. After Japan’s attack on
Pearl Harbour, US stock markets fell by 10%, but recovered within six
weeks. Similarly, after the terrorist attacks of September 11, 2001, US
stocks dropped nearly 12%, but bounced back in a month. After the
assassination of President John F Kennedy, stock prices fell less than
3%, and recovered the next day.
Yes, each political crisis is
different. But through most of them, veteran emerging-markets investor
Jens Nystedt notes, market participants can count on a response from
policymakers. Central banks and finance ministries will almost always
rush to offset rising risk premia by adjusting interest rates or fiscal
policies, and investors bid assets back to their pre-crisis values.
Today,
a conflict with North Korea over its nuclear and missile programmes
tops most lists of potential crises. Open warfare or a nuclear incident
on the Korean Peninsula would trigger a humanitarian disaster, interrupt
trade with South Korea – the world’s 13th largest economy – and send
political shockwaves around the world. And yet such a disaster would
most likely be brief, and its outcome would be clear almost immediately.
The world’s major powers would remain more or less aligned, and future
cash flows on most investments would continue undisturbed.
The same
can be said of Saudi Arabia, where Crown Prince Mohamed bin Salman just
purged the government and security apparatus to consolidate his power.
Even if a sudden upheaval in the kingdom were to transform the balance
of power in the Middle East, the country would still want to maintain
its exports. And if there were an interruption in global oil flows, it
would be cushioned by competing producers and new technologies.
Similarly,
a full-scale political or economic collapse in Venezuela would have
serious regional implications, and might result in an even deeper
humanitarian crisis there. But it would most likely not have any
broader, much less systemic, impact on energy and financial markets.
Such
scenarios are often in the headlines, so their occurrence is less
likely to come as a surprise. But even when a crisis, like a cyberattack
or an epidemic, erupts unexpectedly, the ensuing market disruption
usually lasts only as long as it takes for investors to reassess
discount rates and future profit streams.
By contrast, changes in
broadly shared economic assumptions are far more likely to trigger a
sell-off, by prompting investors to reassess the likelihood of actually
realising projected cash flows. There might be a dawning awareness among
investors that growth rates are slowing, or that central banks have
missed the emergence of inflation once again. Or the change might come
more suddenly, with, say, the discovery of large pockets of toxic loans
that are unlikely to be repaid.
As emerging-market investors well
know, political changes can affect economic assumptions. But, again, the
risk stems less from unpredictable shocks than from the slow erosion of
institutions that investors trust to make an uncertain world more
predictable.
For example, in Brazil, despite an ongoing corruption
scandal that has toppled one president and could topple another,
investors recognise that the country’s institutions are working – albeit
in their own cumbersome way – and they have priced risks accordingly.
The
greatest political risk to global markets today, then, is that the key
players shaping investor expectations undergo a fundamental realignment.
Most concerning of all is the United States, which is now seeking to
carve out a new global role for itself under President Donald Trump.
By
withdrawing from international agreements and trying to renegotiate
existing trade deals, the US has already become less predictable.
Looking ahead, if Trump and future US leaders continue to engage with
other countries through zero-sum transactions rather than co-operative
institution-building, the world will be unable to muster a joint
response to the next period of global market turmoil.
Ultimately, a
less reliable US will require a higher discount rate almost everywhere.
Unless other economic cycles intervene before investors’ expectations
shift, that will be the end of the current market boom. – Project
Syndicate
* Christopher Smart is a senior fellow at the Carnegie
Endowment for International Peace and the Mossavar-Rahmani Centre for
Business at Harvard University’s Kennedy School of Government. He was a
special assistant to the US president for International Economics,
Trade, and Investment (2013-2015) and Deputy Assistant Secretary of the
Treasury for Europe and Eurasia (2009-13).
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A woman holds a sign during an anti-government demonstration protesting for the shortage of medicines in Caracas on November 20. A full-scale political or economic collapse in Venezuela would have serious regional implications.