Twenty years ago, when I was a rookie reporter, a colleague told me that the “problem” with emerging market assets was that they were irritatingly hard to value. That was partly because emerging markets suffered financial crises.
But the bigger issue was politics: emerging markets were more unpredictable than markets in Europe or America because they suffered from political risks such as revolutions, coups and capricious demagogues — or so the theory went.
How times change. A decade ago, investors were forced to rethink one of these assumptions when America and Europe were engulfed by the 2008 financial crisis. Now they are being forced to evaluate a second assumption, about political risk.
Most notably, 2016 was the year when western markets were rocked by political shocks almost as startling as anything seen recently from the emerging markets world. In 2017 investors will probably confront even more political risk in the “developed” world that will make asset values look more volatile.
By any standards, the events of the past few months have been bewildering. At the start of 2016 most investors considered it almost impossible to imagine a scenario where the UK would vote to leave Europe, the US would elect Donald Trump as president or Italian voters would reject the reformist prime minister Matteo Renzi. But all three scenarios played out.
More startling still, markets soared after Mr Trump’s victory — contrary to all predictions. “This has been the year of unpredictability”, as Gary Cohn, the former chief operating officer of Goldman Sachs and new head of Mr Trump’s National Economic Council recently told financiers at a Chicago Mercantile Exchange conference in Miami.
The coming year could be equally unpredictable. France, Germany and the Netherlands will hold elections, just as support for populist candidates is swelling. Theresa May, UK prime minister, is embarking on Brexit negotiations, creating more uncertainty; and markets are waiting nervously to see what Mr Trump does (or does not) do in office, amid a host of conflicting signals.
In theory some of this uncertainty could be contained by the fact that the western world has strong institutions and the rule of law. “Presidents have limited powers,” John Boehner, former speaker of the US Congress, recently told the CME conference. “They don’t get things done unless they have got a Congress which will work with them.”
But with populism rising, institutions are under attack, along with cosy assumptions about how politics “ought” to work. “We are in the middle of a political revolution. Not just in America but Europe too,” Mr Boehner admits. And what makes the pattern doubly unnerving and unpredictable is that it is people, such as Mr Trump, Mrs May or Angela Merkel who are shaping events, rather than established party platforms or policy programmes. “In the old days you could make predictions if you knew which political party was in office,” observes Axel Weber, chairman of UBS. “But now it’s about a person. The pricing of political uncertainty has moved from being an emerging market phenomenon to an emerged market issue.”
Is there any way for investors to adapt to this new world? Not easily. But one place to start is to abandon the idea that asset values can be predicted by using neat economic models alone. Mr Weber, for example, suggests investors urgently need to think about the difference between “risk” and “uncertainty”: the former refers to events that can be predicted with a certain probability; the latter refers to unknown future shocks. Until now, investors in developed markets have tended to focus primarily on risks and assume these can be priced (and hedged against). But 2017 is likely to produce uncertainty. That cannot be easily priced or hedged — and investors should recognise this.
Second, investors should also embrace “optionality”: the only way to prepare for a world of uncertainty is to stay as flexible and diversified as possible. Now is not the time for investors to put all their eggs in one basket, or bet on just one asset class. Nor is it a time for businesses to be locked into rigid business plans; political and geopolitical upheaval could strike almost anywhere.
Third, if 2017 does deliver more risk and uncertainty, expect the markets to be skittish about “news” of all types, and not just economic. If events are being shaped by the capricious decisions of political leaders or unpredictable waves of populism, then every nugget of new information — or tweet — could matter.
That is bad news for anybody who hates market volatility. However, demand for credible news will soar benefiting some of the media. Trading volumes could surge in financial markets too, delivering a boost to some financial institutions. “We are in for some volatility like you have never seen,” predicts Terry Duffy, executive chairman and incoming chief executive of the CME.
It is also worth remembering what savvy investors in emerging markets have long known: that uncertainty can deliver huge opportunity alongside risks. Politics could deliver nasty shocks in 2017; there could be military tensions in Asia; rising trade protectionism; or an upsurge in corporate defaults if the US Federal Reserve raises rates to offset Mr Trump’s reflation policies.
But political shocks can sometimes produce good surprises. Look at how US bank shares and Japanese stocks have unexpectedly rallied after the US election result.
To survive in 2017, investors will need to use tools taken not just from the world of economics, but from psychology, sociology and political science too. Or perhaps find successful emerging markets investors and ask them how they do their craft. Happy — uncertain — New Year.
