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Political risk and emerging market investing: An innovative multi-asset approach

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By Al Clark, Global Head of Multi Asset, Nikko Asset Management – Macro-political risks in emerging markets have notably increased since the financial crisis.

They are by nature, however, challenging to measure and formally incorporate into the investment process, with their effects on asset prices generally under appreciated by investors. Given both the increasing frequency and intensity of such political and economic crises, we believe a more systematic method of measuring political risk and evaluating its impact on market prices is required.

With this in mind, Nikko Asset Management and Eurasia Group have partnered to bring together the latter’s proprietary geopolitical risk indicators within our multi-asset investment management process. We now have a systematic methodology to measure and quantify political risk and its potential impact on emerging market asset prices. The framework includes: (1) country scores that capture current levels of political stability (the Global Political Risk Index), (2) formal assessments of the future outlook for political stability and its impact on the business environment (Political Trajectories), and (3) asset pricing models that estimate the interaction between political risk and market prices.

There is evidence of significant relationships between political risk factors and returns across various asset classes, in areas such as equity index volatility, bond spreads, formed risk premia between spot and forward FX rates and CDS spreads. We have identified five main factors explaining why politics matters so much for asset pricing in emerging markets:

  1. Institutional capacity to manage shocks – Political institutions, government strength, and the relationships between societies and their governments place important constraints on the ability of governments to manage adverse internal and external economic shocks.
  2. Policy uncertainty – Asset prices, of course, are sensitive to actual policy changes, but also to ‘headline risk’ around elections and other signals of potential future changes to policy.
  3. Competition and operating environment – Politics determines the ‘rules of the game’ for producers and consumers.
  4. Sovereign creditworthiness – Politics and policy choices directly impact the ability and willingness of governments and state-owned enterprises to pay debt.
  5. Market structure can amplify political shocks – Unanticipated political shifts can cause large and very fast shifts in desired portfolio balances, resulting in large price adjustments.

Over the last 25 years, emerging market equities have outperformed developed market equities by 3.3 per cent per annum. These higher returns naturally came at the expense of substantially higher risk. Over the same period, the annualised volatility of emerging market equity returns was 23 per cent p.a. In comparison, developed market equities had much lower volatility of 15 per cent p.a. Higher risk was accepted as a necessary pre-condition for enjoying the higher returns provided by Emerging Markets. However, recently investors have begun to question whether they will be adequately compensated for this additional risk.

To understand the changing nature of macro-political risk, we constructed an Emerging Market Multi-Asset portfolio and assessed the change in contribution to risk from different asset classes over time. The portfolio consisted of an equally weighted allocation to Emerging Market equities, hard currency bonds and local-currency bonds (currency was disaggregated and treated as a stand-alone risk). Before 2008, the equity portion (largest source of stock-specific risk) contributed the lion’s share of portfolio volatility – roughly 70 per cent, compared to 20 per cent from currency and about 10 per cent from the bond portion. Since the global financial crisis in 2008, currency and bond volatility (the largest sources of macro-political risk) have increased greatly, now comprising more than 50 per cent of portfolio volatility.

As macro-political risk contributes more to portfolio volatility, we believe a top-down investment approach to managing EM portfolios is a superior approach. Such an investment philosophy recognizes both the increasing importance of macro-political risk on EM asset returns as well as the rapid evolution of capital markets across many of the larger emerging countries. We believe a top-down approach should consist of the following three key pillars:

  1. Broadening the investment opportunity set from just equities to multiple asset classes (equities, local-currency bonds, hard currency debt and FX) to add additional sources of returns and lower overall portfolio risk;
  2. Dynamic management of risk allocations to these asset classes to protect downside risk; and
  3. A systematic methodology for measuring and quantifying political risk and its potential effects on Emerging Market asset outcomes.

In times of political crises, the dispersion between assets declines, and the importance of dynamic top-down, country and asset allocation becomes integral in managing downside risk. These approaches have been incorporated into Nikko Asset Management’s multi-asset approach, which captures the increasingly broad sources of return within emerging markets and factors in macro risks, along with valuation and momentum, to be able to manage significant downside volatility. We believe this approach offers global investors the best risk-controlled means of gaining exposure to emerging markets.
 
 

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