Political risk: the invisible touch

2014 has rapidly turned into the year of geopolitics, with events affecting
investors across pretty much all continents.

From Russia’s involvement with Ukraine, to China’s outlook on territorial waters, 2014 has been shaping up as the year of geopolitics being one of if not the key investment factor.

Serena Giordano, vice president and Product Specialist at Deutsche Asset & Wealth Management in Milan sees the move by central banks to downscale their stimulus policies as leaving a vacuum, which is being filled by geopolitics as a factor affecting financial markets, prices and flows of capital.

“In 2014, many emerging market countries will be going to the polls. The
outcomes of elections in unstable countries such as Egypt, Turkey, Ukraine – now without Crimea – South Africa and Indonesia are all a potential source of volatility,” she says.

“However, let’s not forget that many outflows from emerging market debt and equity seem to have stopped recently and the strong depreciation of EM currencies, together with the reforms that are underway or have been announced by candidates, can represent a positive turning point.”

It is important to recognise that as a factor political changes are not necessarily harbingers of downside risk. FMG, the Malta headquartered
manager, which has been invested in frontier markets since the mid-1990s, has said recently that the ability to bring its oil industry on stream means that Iraq could become the second fastest growing economy over the coming 10 years, as it starts to compete with Russia and Saudi Arabia as one of the biggest oil exporters.

Other markets in the Middle East North Africa (MENA) region remain challenging because of the risk associated with politics, but valuations mean that they remain attractive markets in which to do business, according to FMG.

Further afield, SooHai Lim, investment manager of the Baring ASEAN Frontiers Fund, sees the raft of elections hitting the Association’s member states as an opportunity.

“The second half of this year could be particularly rewarding for investors. Jakarta governor Joko Widodo is his party’s nominee for the July presidential election and this could be good news for investors given his successful track record of reform.

“Barings anticipates that under his leadership, Indonesia will embark on further reforms more decisively and that will support Indonesia’s medium-term growth outlook.”

Still, there are some warning signs, and investors in the ASEAN region also express frustrations over ongoing political uncertainty.

“Year-to-date foreign investors have net sold about $900m worth of stocks in Thailand – coming on top of the $6bn outflows last year. While in the short term investors are clearly concerned about political developments, whether that affects sentiment in the longterm will depend on how the political situation evolves.

“A new functioning government, albeit an interim one, would likely have to
address the economy among its agenda, and the market should, in this scenario, react positively.”

For emerging market investors generally the issue of politics is something that has to be considered as part of the package of factors – along with those such as accounting practices and investor protection – that make it an asset class offering potentially greater rewards against higher levels of risk.

That is a point noted by Duncan Hodnett, director of Institutional Business Development, Europe, and Paul Bouchey, managing director, Research at Parametric, one of the brands offered by Eaton Vance.

The point of emerging market investing from their perspective is not to necessarily find the highest growth stocks, or cheapest stocks, but how to manage higher levels of risk – not to get rid of it, but to manage it – they suggest.

One answer is to invest broadly across a number of countries; in Parametric’s case it is to look across more than 40 or so and rebalance as events and valuations change. Investing in single countries results in significantly higher risk as the likes of Ukraine have shown recently.

The ‘hot’ example of political risk in Europe has escaped nobody’s attention, marking as it does in the eyes of many observers the beginning of a new type of relationship with one of the EU’s biggest suppliers of energy and raw
materials – Russia.

Monica Defend (pictured), head of Global Asset Allocation Research at Pioneer Investments in Milan, has said recently that the crisis between Russia and Ukraine “may make markets volatile, but we need to evaluate Russia’s next steps to assess the risk facing not only European but also global equity markets.”

“A military intervention in eastern Ukraine with implications for social stability, would spark even more volatility amid fears of a civil war, whereas the impact on markets would be contained if the crisis stopped in Crimea for now. We believe it is not in Russia’s interest to exacerbate relations with Europe due to the sizeable foreign trade.

“Ukraine for its part is a midsized economy and shouldn’t have wider implications, but this too may change if the crisis involved other Great Powers (US, China) and a sharp rise in oil prices would be a clear indication of that as Russia is of course a major exporter.”

For Europe the key hydrocarbon threat might not be oil, but gas. Platts, the specialist provider of commodities markets data and prices, reported comments on 8 April from Ukraine’s energy minister Yuriy Prodan, to the effect that shipments of gas to Europe via Ukraine could be threatened by the significant price increases passed on by its Russian suppliers.

“In this situation [of a high gas price for Kiev], there is a risk of halts in gas supplies to Ukraine and corresponding threat of halts in transit of gas to Europe because Ukraine’s options for maintaining transit are limited,” Prodan was originally quoted by Russian news agency Prime.

Platts noted that the gas price quoted for Ukraine increased by 80% to $485 per 1,000 cubic metres between the first and second quarters of 2014.

The EU meanwhile faces its own internal political hurdles in the near
future. Consider the debate in the UK around the Scottish referendum,
scheduled for 18 September which has raised many questions regarding
monetary policy affecting the pound – the pro-independence camp are arguing for a currency union to remain with what would be left of the UK – England, Wales and Northern Ireland – while those against independence say this will not be workable.

In Spain there is a call to hold a referendum on Catalonian independence on 9 November, which, in contrast to the Scottish referendum, had not at the time of writing been accepted as a valid exercise in democracy by either
Spain’s central government or the country’s Constitutional Court.

Maria Paola Toschi, executive director and Global Market strategist at JP Morgan Asset Management, and her colleague Kerry Craig, vice president and Global Market strategist, earlier in 2014 noted the danger in so-called
‘austerity fatigue’ experienced in a number of European countries.

This has led to concern of a rise in populist policies. “Heavy-handed austerity has helped to reduce deficit-to-GDP ratios, but often at the expense of economic growth and heightened social tensions.

“Thankfully, there will be somewhat less austerity in the coming years, but European politicians must work to overcome continued divergence in policies
and the performance of economies within the single currency area if they are going to create a more favourable environment for sustainable growth,” Toschi and Craig wrote.

They added: “Voter interest in EU politics has waned over time, but this year’s election could see an increase in voters who want a less integrated Europe and to protect national sovereignty.”

“Eurosceptic parties could gain up to 25% of the vote in the European Parliament elections.”

One of the prime movers of both upside and downside risk associated with politics is the internet. Consider, for example, how Turkey’s government moved to ban the social networking service Twitter at the time of local elections in the country earlier this year.

The attempt backfired as the country’s Constitutional Court rejected the
move. It showed the importance of new information technology involved in
the dissemination of ideas ahead of or during elections.

The bar chart right shows how internet usage has changed in a number of countries affected by higher political risk – regardless of whether the incumbents have won in elections that have already taken place this year, or are set to take place later in the year.

Use of social networking has been proposed as being of benefit to investors in that it could reduce the risk of speculative panic affecting markets, or indeed attitudes towards products.

Tundra Fonder – the Swedish manager whose Russia fund returned more than peers available on the PPM platform for long term savings through the last quarter of 2013- has been providing running commentary on the situation in Ukraine, Crimea and Russia via its Facebook page since those particular events moved up the agenda in light of the referendum and subsequent annexation of the territory into Russia.

What is less certain for investors is understanding the impact of this type of use of IT in a way that means it can be plugged into modelling.

One fund buyer who is already looking to try to imply a certain measure from the way factors such as elections are addressed by IT is Swedish manager Aktiva Fonder Asset Management.

Christer Hultblad, CEO and portfolio manager, says that the manager uses different Big Data tools for sentiment analysis in the investment process.

An example would be “Putin”. The screening does not look at how many
times “Putin” is mentioned online, but seeks to contextualise this. The screening enabled Aktiva to see a spike before the Crimea crisis worsened, Hultblad says, adding: “We see a new status quo appearing, but things will normalise – the world is globalising and countries cannot lock each other out.”

“The West did not believe the world police would be in the east rather than in the west, so it was unprepared for the Russian response.”

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