For a long time, political risk took on different meanings whether you were investing in developed markets or in emerging economies -- with the robustness of institutions as the major differentiator. In the past eight months, however, the distinction has become a lot less stark, as a growing number of investors started to wonder how best to respond.
For investors in developed markets, political risk has usually been contained to changes within relatively narrow bands that revolved around the policy stance of governments toward budget deficits and composition, deregulation and, at times, trade and capital liberalization. To use economist lingo, it was about movements along curves, rather than a major step-shift in these curves.
That wasn't the case for investors in emerging markets, where the political risk could easily involve radical shifts in economic orientation, the specification of trade and capital controls, the operation of the exchange-rate system and, even, policies of nationalization and confiscation. Moreover, as illustrated by the case of Yukos, the once-powerful Russian oil giant, it could also entail the complete disruption of an otherwise healthy and profitable company.
In explaining this notable difference, the credibility and stability of institutions and respect of the rule of law served as one of the most important contributing factors. These characteristics anchored the economic and financial setup, maintaining overall economic stability and relative predictability.
Until recently, this distinction managed to withstand quite a few changes -- including in Greece where the Syriza government, a coalition of the radical left, was voted into power in 2015 on the promise of major policy changes, but ended up pursuing essentially the same approach as its much more conventional predecessor.
Then there was the Brexit referendum. David Cameron, the then-prime minister and leader of the Conservative Party, made what is now regarded as a major political miscalculation by holding a referendum in June of last year on whether the U.K. should exit the European Union. The surprising victory of the “leave” campaign forced Cameron out of office and the vote now confronts investors and businesses with major questions about the legal framework that will govern the country’s economic and financial relations with its major trading partner.
Now its France’s turn to inject political risk into markets.
In the run-up to this spring’s presidential elections, unusual and unexpected developments in the traditional parties on both sides of the spectrum have opened up the possibility of Marine Le Pen, the leader of the extreme-right National Front, making a serious run for the Elysee Palace. With her party platform calling for exiting the euro zone, the trading of French government bonds surged last week and risk spreads have widened vis-à-vis German bunds.
As a result, investors seem more conflicted about how to treat political risk when it comes to the pricing of developed market bonds, stocks and foreign exchange. Understandably, few see the need -- at least for now -- to adopt an emerging-market methodology. But doing nothing is becoming increasingly uncomfortable given that anti-establishment movements are gaining traction in several advanced countries.
The answer may well be in a slow and gradual evolution rather than a revolution.
It is unlikely that markets will be able to ignore the overall increase in developed-market political risk. As such, many volatility measures, with the notable exception of extreme tail (or plunge) protection, remain too low. After all, the effects of too many years of economic growth that is too feeble and insufficiently inclusive have fueled a combination of political anger, distrust of institutions and loss of confidence in expert opinion, whether formed in the public or private sectors. But the developed-markets' rule of law, self-interest -- even if not of the most enlightened variety -- and longstanding systems of checks and balances are likely to act as constraining forces that limit the likelihood of a tip into an emerging markets-like pricing regime.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE and chairman of the President’s Global Development Council, and he was chief executive and co-chief investment officer of Pimco. His books include “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse.”
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