Greece Isn’t the Only Political Risk

Europe Vote

Following the “no” vote in Greece’s national referendum on whether to accept the bailout terms proposed by its European creditors, the two sides continue to struggle to reach an agreement that would keep the country in the euro zone. For investors, the Greek crisis highlights the importance of “political risk,” the idea that the value of your investments can be hurt by political factors in addition to purely economic or financial ones.

In the case of Greece, the political risk for most investors should be fairly small. As we’ve noted in the past, Greece’s economy makes up less than one third of one percent of the global economy, and the size of its stock market is negligible compared to the global market. But the Greek crisis has the potential to exacerbate other political risks in Europe that could have a larger effect.

One is the possibility that—like the Syriza party in Greece—anti-establishment political parties could come to power elsewhere in Europe and cause further political and economic fragmentation of the continent. Such parties have even gained popularity in some of the largest European countries. In France, which makes up over 3% of the global stock market, the National Front party has made gains in recent years. In Spain, which makes up over 1% of the global stock market, the Podemos party is vying to win the national election that will be held later this year.

Another risk is that the United Kingdom (which has its own currency and therefore isn’t a part of the euro zone) will leave the European Union. The country’s prime minister, David Cameron, has pledged to hold a national referendum on whether the country should leave the EU. Leaving a political group such as the EU likely wouldn’t cause as much financial upheaval as a country leaving a currency union such as the euro zone, but it could harm many British companies.

The outcome of Greece’s current crisis will affect these other political risks. The disorderly financial collapse that Greece has suffered in recent weeks has probably made it less likely that other struggling countries will risk leaving the euro zone by trying to extract more favorable terms from their creditors. If Greece leaves the euro zone and its economy recovers, however, other countries may view a euro zone exit as a more enticing possibility. Furthermore, a breakup of the euro zone could make it more likely that the UK votes to leave the EU. The political risk from Europe is far from over.

The Big Trends in the Global Economy

Global Growth

A lot has seemingly happened in the global economy in recent months, from a plunge in the oil price to a surge in the value of the US dollar against foreign currencies to an election in Greece that led to renewed fears about the possibility that the euro zone would break apart. But what’s been the upshot of all these changes? The latest World Economic Outlook report from the International Monetary Fund provides some data to answer that question.

According to the IMF’s report, the global economy is expected to grow by 3.5% this year. That’s lower than the projection of 3.8% growth that the IMF made six months ago. The change is largely the result of slower expected growth from emerging markets (5.0% six months ago versus 4.3% now). The prospects for developed economies, on the other hand, have actually improved slightly. While the estimated 2015 growth for the US hasn’t changed (it’s still 3.1%), the IMF boosted its growth estimates for the euro area and Japan.

Even though expectations have declined for emerging economies as a whole, not every country has a similar story. Six months ago the IMF expected a positive growth rate this year in Russia and Brazil; now it expects both countries’ economies to get smaller. The anticipated growth rate for China has also declined, although it’s still very high at 6.8%. India has gone in the other direction. Six months ago the IMF was projecting that India’s growth this year would be 6.4%. The latest estimate is 7.5%.

It’s important to remember that there’s only a weak link between economic growth and stock market performance, so simply buying stocks of fast-growing countries (or stocks of countries where the economic outlook has improved) probably isn’t a good idea. In fact, China and Russia have been among the best-performing stock markets so far this year. Still, thinking about the global economy in terms of these numbers may make the big-picture trends more apparent.

The Biggest Political Risks in 2015

Europe Vote

2014 was filled with political risk, a concept referring to political changes that can affect the value of an investment. From Russia’s military adventurism in Ukraine to renewed US military involvement in the Middle East, headlines were filled with geopolitical turmoil. But despite all the potential political conflicts, the ones that ended up metastasizing only minimally affected most investors. Even Russia comprises well below 1% of the global stock market. Political conflicts that could have more dramatically affected financial markets—such as China’s territorial disputes in the South China Sea and Scotland’s independence referendum—mostly fizzled out without causing too much financial damage. That could change in 2015 as political risk in Europe intensifies.

The surge of political risk in Europe has been caused by the rise of radical political parties that are less favorable toward European integration. Their support has been bolstered by the continent’s slow economic growth, a backlash against so-called “austerity” policies to reduce governments’ budget deficits, and disagreements between countries with struggling economies (such as Greece and Spain) and countries with stronger economies (such as Germany) over who should bear the cost of boosting economic growth.

There are a number of countries where these parties could potentially take power. Polls in Greece suggest that the radical Syriza party could win in the country’s parliamentary elections later this month. The party has pledged to fight for better terms for Greece from its international creditors, which has led to fears that a Syriza victory could lead Greece to exit the euro zone.

Radical anti-establishment parties in other countries could also achieve success in elections this year, such as the Podemos party in Spain, the Danish People’s Party in Denmark, and the UK Independence Party in the United Kingdom. Financial markets face additional uncertainty in the UK election, where Prime Minister David Cameron (from the mainstream Conservative Party) has pledged to hold a nation-wide vote on whether the UK (which is not part of the euro zone) should remain as a member of the European Union.

With so much electoral uncertainty in Europe, and even uncertainty about whether the euro zone and European Union will stay intact over the next few years, managing political risk will be a difficult. But that doesn’t mean investors should abandon international markets, or even abandon Europe. The lesson from 2014, when some countries viewed as politically risky (such as Russia) suffered cratering stock markets while others (such as China) performed well, is that being well-diversified internationally can be a good way to handle political risk.

The Possibility of European Deflation

Euro zone inflation rate

The euro zone has struggled mightily in recent years, with its economy shrinking in both 2012 and 2013. Now it faces a new worry. Inflation in the euro zone has fallen to a 0.4% annualized rate, well below the target of close to 2% set by the European Central Bank (ECB) and close to outright deflation. The dangers of high inflation (a sustained rise in the prices of goods and services throughout the economy) are well known: it reduces the value of people’s savings and can make individuals and businesses reluctant to invest. So shouldn’t deflation (a decline in prices) be beneficial? Not exactly.

There are a number of ways that deflation harms an economy. First, since the amount owed on loans and bonds stays the same even if the price of goods and services decline, deflation can make it more difficult for individuals, businesses, and governments that have borrowed money to get out of debt. Just as inflation hurts bondholders, deflation hurts debtors.

Second, it tends to be easier for companies to raise wages than to make their employees take pay cuts. Therefore if prices are declining so companies can’t pay their workers as much, they are likely to lay off more employees, leading to higher unemployment.

Third, when people see prices falling they may respond by postponing their purchases until prices go down even further. A decline in prices can therefore lead to reduced demand, causing further price declines (a “deflationary spiral”).

The euro zone may already been feeling some of these effects, since they can start to kick in when the inflation rate is persistently low, even if it’s still above zero.

Unlike the central banks of other developed countries such as the US, UK, and Japan, the ECB hasn’t engaged in “quantitative easing” (essentially creating new money and using it to buy bonds). This difference is one reason why expected future inflation is now substantially lower in the euro zone than in the US or UK. To avoid the perils of deflation, the ECB may need to take more aggressive action to prop up the continent’s economy.

The Rise of Political Risk

One important trend in global financial markets during the last few years has been a rise in political risk, a concept referring to political changes that could affect the value of an investment. The number of events associated with political risk—such as elections, mass protests, and military interventions—has increased by 54% since 2011, according to a study by analysts at Citigroup. This kind of increase has a couple key implications for investors.

The first is that it can affect the relative performance of emerging markets versus developed markets. Interestingly, while political risk has historically been most closely associated with poorer countries, in recent years it has appeared in some of the wealthier emerging markets and even developed ones.

In emerging markets there have been protests in a wide range of countries, including Brazil, Russia, South Africa, Thailand, and Turkey. In developed markets, political posturing opened up the possibility that the United States government would default on its debt in the summer of 2011, and extremist parties opposed to the European Union did well in recent elections for the European Parliament.

A continued increase in political risk would likely hurt emerging markets more than developed markets, even if the risks aren’t isolated to emerging markets themselves. Investment typically flows from emerging markets into “safer” markets (such as the United States, Switzerland, and Japan) when perceived risk increases. This shift can take place even when the risk originates in the developed countries, as was the case when emerging markets were pummeled during the 2008 financial crisis.

A second implication of increased political risk is that it may lead to more divergence in the performance of stocks in different countries. This trend is already evident in some of the countries that have recently experienced notable political events. For example, Russian stocks have lost 8% so far this year (and at one point were down close to 25%) as the country became involved in territorial battles with Ukraine. Indian stocks, by contrast, have risen more than 20% this year as political power shifted in the country’s May elections.

EM 2014 Performance