During the financial crisis I found that mugging up on economic history, particularly from emerging markets, was often more helpful than talking to conventional policymakers hooked on their fair-weather economic models. The rise of economic nationalism and the threat to globalisation means I find myself using emerging market parallels again. I cannot help wondering if investing in western markets may become more like investing in emerging markets.
Emerging markets require an intense focus on country risks and political economy. Investors in the west have long been able to ignore political risk and focus on sectors’ or individual companies’ prospects. But the prospect of a new independence referendum in Scotland is only the latest in a series of shocks to the institutional fabric of western countries.
Careful monitoring of the strength of political institutions and corporate governance issues are central to successful emerging market investing and can have a profound impact on valuations and long-term growth expectations. Our analysis suggests country risk can account for as much as half of investors’ returns. Little wonder the market for political risk analysis is booming. Since the crisis some domestic sectors have already been severely affected by this. US banks are up 51 per cent in the past 12 months, whilst British banks have fallen 21 per cent for international investors.
Emerging markets teach us that economic nationalism is often inflationary. In the west, after an excessive reliance on monetary policy, a reflationary regime-change in trade, fiscal and regulatory policies is welcome. But emerging markets’ experience suggests we should watch carefully how this plays out. In the early stages of programmes, the reactivation of the economy is often positive as employment increases. But emerging markets diverge later on. Some succeed strongly. For others, weak investment and poor productivity often follow, and the interaction of a rise in inflation and inequality can feed the politics of anger.
Currency volatility is higher under economic nationalists. Emerging markets also show us that populism is infectious. Across Europe, populist parties could have a material impact on elections in the Netherlands, France and Italy. The feedback loop from the US election and UK referendum on European contests is also strong.
Populists typically have put far more political pressure on their country’s institutional fabric. Although we have seen growing challenges, not least to central banks’ independence, we assume the strength of western institutions will win out. But this pathway doesn’t need to be negative. The threat of protectionism may prompt stronger policies to boost domestic growth - which Europe sorely needs.
Historical parallels can only take us so far. Alongside the surge in economic nationalism, profound shifts in technology are having an impact on work, culture and politics. Since technological change is here to stay, the impact will keep growing. A destabilisation of markets and economies is the consequence and a different distribution of economic and financial returns is the result.
A guiding principle for investors over the past 30 years has been convergence - whether it be emerging markets catching up with developed ones, or eastern and southern European economies converging on western Europe. Quantitative easing has helped suppress divergence, but can no longer be taken for granted. If we are investing in a more divergent world, then the emerging market toolkit, alongside an understanding of how technology is reshaping societies and markets, will be critical.