The real risk to global economy

Oneof the great mysteries of today’s global markets is their irrepressibleenthusiasm, even as the world around them appears on the verge of chaosor collapse. And yet, investors may be more rational than they appearwhen it comes to pricing in political risks. If investing is foremostabout discounting future cash flows, it’s important to focus preciselyon what will and will not affect those calculations. The potentialcrises that may be most dramatic or violent are, ironically, the onesthat the market has the easiest time looking through.Far moredangerous are gradual shifts in international global institutions thatupend expectations about how key players will behave. Such shifts mayemerge only slowly, but they can fundamentally change the calculus forpricing in risks and potential returns.Today’s market is easy toexplain in terms of fundamental factors: earnings are growing, inflationhas been kept at bay, and the global economy appears to be experiencinga broad, synchronised expansion. In October, the International MonetaryFund updated its global outlook to predict that only a handful of smallcountries will suffer a recession next year. And while the majorcentral banks are planning, or have already begun, to tighten monetarypolicy, 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 20thcentury, markets bounced back fairly quickly. After Japan’s attack onPearl Harbour, US stock markets fell by 10%, but recovered within sixweeks. Similarly, after the terrorist attacks of September 11, 2001, USstocks dropped nearly 12%, but bounced back in a month. After theassassination of President John F Kennedy, stock prices fell less than3%, and recovered the next day.Yes, each political crisis isdifferent. But through most of them, veteran emerging-markets investorJens Nystedt notes, market participants can count on a response frompolicymakers. Central banks and finance ministries will almost alwaysrush to offset rising risk premia by adjusting interest rates or fiscalpolicies, and investors bid assets back to their pre-crisis values.Today,a conflict with North Korea over its nuclear and missile programmestops most lists of potential crises. Open warfare or a nuclear incidenton the Korean Peninsula would trigger a humanitarian disaster, interrupttrade with South Korea – the world’s 13th largest economy – and sendpolitical shockwaves around the world. And yet such a disaster wouldmost likely be brief, and its outcome would be clear almost immediately.The world’s major powers would remain more or less aligned, and futurecash flows on most investments would continue undisturbed.The samecan be said of Saudi Arabia, where Crown Prince Mohamed bin Salman justpurged the government and security apparatus to consolidate his power.Even if a sudden upheaval in the kingdom were to transform the balanceof power in the Middle East, the country would still want to maintainits exports. And if there were an interruption in global oil flows, itwould be cushioned by competing producers and new technologies.Similarly,a full-scale political or economic collapse in Venezuela would haveserious regional implications, and might result in an even deeperhumanitarian crisis there. But it would most likely not have anybroader, much less systemic, impact on energy and financial markets.Suchscenarios are often in the headlines, so their occurrence is lesslikely to come as a surprise. But even when a crisis, like a cyberattackor an epidemic, erupts unexpectedly, the ensuing market disruptionusually lasts only as long as it takes for investors to reassessdiscount rates and future profit streams.By contrast, changes inbroadly shared economic assumptions are far more likely to trigger asell-off, by prompting investors to reassess the likelihood of actuallyrealising projected cash flows. There might be a dawning awareness amonginvestors that growth rates are slowing, or that central banks havemissed the emergence of inflation once again. Or the change might comemore suddenly, with, say, the discovery of large pockets of toxic loansthat are unlikely to be repaid.As emerging-market investors wellknow, political changes can affect economic assumptions. But, again, therisk stems less from unpredictable shocks than from the slow erosion ofinstitutions that investors trust to make an uncertain world morepredictable.For example, in Brazil, despite an ongoing corruptionscandal that has toppled one president and could topple another,investors recognise that the country’s institutions are working – albeitin their own cumbersome way – and they have priced risks accordingly.Thegreatest political risk to global markets today, then, is that the keyplayers shaping investor expectations undergo a fundamental realignment.Most concerning of all is the United States, which is now seeking tocarve out a new global role for itself under President Donald Trump.Bywithdrawing from international agreements and trying to renegotiateexisting trade deals, the US has already become less predictable.Looking ahead, if Trump and future US leaders continue to engage withother countries through zero-sum transactions rather than co-operativeinstitution-building, the world will be unable to muster a jointresponse to the next period of global market turmoil.Ultimately, aless reliable US will require a higher discount rate almost everywhere.Unless other economic cycles intervene before investors’ expectationsshift, that will be the end of the current market boom. – ProjectSyndicate* Christopher Smart is a senior fellow at the CarnegieEndowment for International Peace and the Mossavar-Rahmani Centre forBusiness at Harvard University’s Kennedy School of Government. He was aspecial assistant to the US president for International Economics,Trade, and Investment (2013-2015) and Deputy Assistant Secretary of theTreasury for Europe and Eurasia (2009-13)..