Investors underestimating risk in emerging market stocks

Investors underestimating risk in emerging market stocks
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Despite political turmoil, investors remain bullish on emerging market equities. Is this because of improved understanding of risk, or complete misunderstanding?

When the ‘taper tantrum’ hit for a second time at the beginning of 2014, equities in emerging markets seemed to be a poor investment choice. To add to that sentiment, conflicts erupted in Ukraine, Gaza, and Iraq, Argentina was in a cross-border bond battle, and concerns about China’s economy and territorial claims mounted. Given these headwinds, the performance of emerging market stocks since then is even more impressive. Since the beginning of 2014, emerging market stocks have outpaced the S&P 500, gaining nearly 13% versus the S&P 500’s gain of nearly 10%.

Investors’ attitudes towards emerging markets seem overly optimistic given the risk environment. Most of the discussion of these risks has focused on the impact of low-interest rates in developed economies and the reach for yield, anticipating a redux of the temper tantrum. The political risk associated with emerging market stocks is less of a discussion. While there appears to be greater sophistication in understanding this risk, investors are still far too optimistic in many respects.

The Modi effect

The markets’ optimism in India, which had been scarce for the past several years, surged after the election of Prime Minister Narendra Modi. With just the prospect of pro-market reforms and easier access to 1.2 billion consumers, markets reacted: The S&P SENSEX index, a bellwether of Indian equities, is up over 10% since Modi’s late May election. A similar narrative can be found in Indonesia, where Joko Widodo was elected President in July, and to a certain extent in Thailand. Thai leaders, having taken power in May after a military coup backed by Bangkok’s middle and upper class, are actively courting investors.

Stephen Cohen, Chief Investment Strategist at iShares, attributes the Indian and Indonesian elections to speculation and optimism across emerging markets. This sentiment ignores the political risks associated with other governing transitions. Turkish Prime Minister Recep Tayyip Erdogan’s strongman reputation and penchant for interfering with the central bank could pose significant risk in a large and quickly growing European market. The elections left for the last three months of the year, most notably Brazil’s, may hold much more ambiguous results for investors than India.

Still underestimating systematic risk

Even as political risk flares up in emerging market countries, investors are increasingly confident that a well-diversified portfolio – across both sectors and geographies – will shelter them from losses. This downplays the systematic risk that emerging markets will be subjected to the same negative shock. This attitude may be a product of naïve assumptions about the shape of risk, in particular the chances of large negative shocks. A lack of understanding of these risks played a major role in the 2008 financial crisis; it seems that investors have not taken this message to heart in their emerging market investments.

Some of these systematic shocks are not easily predictable, but others are already presenting themselves. If the slowdown of the Chinese economy is prolonged, a shock will be felt systematically across emerging markets. Chile, Colombia, Russia, and South Africa are the most exposed to the Chinese economy, but a total of eight countries’ exports to China are double-digit contributors to GDP. This is the type of shock that will reverberate across emerging markets, and will undermine the geographic diversification approach.

Areas of better political risk management

The question running wild through the finance and economics world this year has been why volatility has remained so low while conflicts in the Middle East and Ukraine have boiled over. One part of the answer has to do with low-interest rates across developed economies and the reach for yield. Another major aspect appears to be the product of more sophisticated emerging market investing.

Not all industries have benefitted equally during the emerging market rally since March. Defensive stocks have led the growth, while highly-cyclical industries have had a much more muted performance. For example, using data from Morningstar, the companies represented in the S&P’s consumer staples index are valued at an average of over 27 times earnings; the S&P’s consumer discretionary index companies are valued at an average of 20 times earnings.

This appears to be the result of political risk management strategies. Amid the wild swings, from the second temper tantrum in February and March to today’s rally, consumer staples have also been much less volatile than consumer discretionary. By staying away from highly cyclical emerging market stocks, investors are shying away from the industries most affected by political risk.

While it is encouraging to see investors take a more nuanced stance on emerging market equities, especially since it benefits companies that may be further away from political risks, acknowledgement of systematic risks is low. This may be because of overly optimistic outlooks on political transitions across emerging markets, or from a low rate environment in developed economies. But regardless of what drives the under-appreciation of risk, investors may have a surprise on their hands if a Chinese slowdown permeates other economies, or yet-unforeseen risks emerge.

Categories: Economics, International

About Author

Alex Christensen

Alex is an Editor at Global Risk Insights, who also currently works in investment research. His work on political risk and economic policy has appeared in many forums, including Business Insider, Seeking Alpha, Oilprice.com & The Emerging Market Investors Association. He holds a Master’s in Economics from the London School of Economics and BA from Washington University in St. Louis.