The Biggest Political Risk

China-US Diplomacy

We recently discussed the rise in political risk that investors have had to deal with over the past few years. But where is this risk most likely to have a meaningful impact on US investors? The answer, perhaps surprisingly, is East Asia.

That answer may seem odd given the political uncertainties in other parts of the world. Syria has been racked for years by a deadly civil war, Iraq’s government is trying to fight off an insurgency, Russian-linked separatists have been stirring up trouble in Ukraine, and military leaders have claimed power in countries such as Egypt and Thailand. But when it comes to global financial markets, these countries are bit players. Even Russian stocks comprise only about one half of one percent of the value of the global stock market. While it’s true that events in small countries can have an impact—trouble in Syria or Iraq could spread throughout the Middle East and affect global oil supplies, for example—political risks related to larger countries would be more consequential.

Since 2012, a diplomatic conflict has been escalating between China and Japan over a group of uninhabited islands in the South China Sea. China also has territorial disputes with other countries in the region, including Malaysia, the Philippines, and Vietnam. So far these conflicts have remained mostly diplomatic rather than military disputes, but there are routinely provocations that threaten further escalation. Last month China stationed an oil rig in territory claimed by Vietnam, leading to riots in Vietnam targeting foreign businesses.

A military conflict between any of these countries could roil financial markets: Japan is the second-largest country in the iShares MSCI All Country World Index ETF, while China is the ninth-largest. Furthermore, the United States could intervene in such a situation (the US has a security agreement with Japan), making the strife truly global.

The good news is that the probability of a large-scale military conflict is still very low. Yet even if the disputes remain the purview of diplomats, investors could feel some effects: trade between China and Japan has fallen substantially since their territorial squabble metastasized in 2012.

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