By Cherry Reynard.

Politics were all-pervasive in 2016 and with European elections looming and Donald Trump busy in the White House, they look set to dominate once again in 2017. This may be new for those operating in developed markets, but emerging markets investors have long had to consider political risk. To what extent should politics influence investment decision-making?

Political risk tends to be obvious with hindsight, but difficult to assess ahead of time: Even experienced pollsters failed to predict the victories of Donald Trump and the ‘Leave’ campaign in the UK. Plenty of investors have come unstuck trying to guess the outcome of major shifts in the political landscape.

Part of the problem is that even if an investor manages to predict the correct outcome of a particular political event, it is near-impossible to quantify its impact on markets. Few predicted a Trump-inspired rally, or that Brexit would be absorbed by markets with relative ease. In Brazil, after a lengthy decline, the stock market turned when political risk seemed to be at its height. Dilma Rouseff was impeached in December 2015; the Bovespa index started to rally from January 2016 (1.).

Equally, poor politics do not necessarily lead to weak financial markets. For example, Pakistan has been one of the best-performing markets over the past five years, seeing a near-300% rise (2.). Yet its politics remain messy. It came 116^th out of 174 countries in the Transparency International Global Corruption Perception index (3.).

As such, to invest based on the potential outcome from a binary event would seem cavalier at best, extremely risky at worst.

However, this is not to suggest that politics don’t matter or that it shouldn’t be considered. Politics can have a significant influence on a country’s currency, or the liquidity of its stock market. It can affect trading relationships and cross-border markets, which in turn can affect companies’ ability to operate effectively. In the worst case scenario, governments may appropriate assets, as happened under Cristina Fernández de Kirchner’s rule in Argentina.

Nevertheless, political turmoil can also present buying opportunities when it blinds investors to the reality of a country or company’s prospects. The market may often overshoot, overestimating the problems. For an investor who can appraise the situation effectively, this allows them to buy shares at below their value.

This may currently be happening in Mexico. The currency and stock markets have sold off considerably in the wake of Donald Trump’s election. The fear is that his drive to ‘make America great’ will come at the expense of Mexican prosperity.

However, will US companies really bring back production from Mexico on a meaningful scale? The cost of manufacturing in the US could be significantly higher, driving up the cost of goods and services. This would be unpalatable for those companies and consumers forced to bear the costs. In spite of the headlines, the risks may not be profound in the longer term. Mexico may, at some point, present a contrarian buying opportunity.

While we can’t predict political outcomes better than anyone else, we can judge whether it reflected in stock market valuations. In this, it helps to have a contrarian mindset. In Brazil, for example, the market had clearly priced in the impeachment. As such, it was cathartic when it finally happens. Equally, while ratings downgrades can appear dramatic at the time, markets often do not react strongly: This is because the ratings agencies are often the last movers. The market is usually aware that a downgrade is coming.

Where we become nervous about political risk is where it is unexpected and markets are taken by surprise. In India, the withdrawal of high valuation notes came out of the blue. This shift from orthodox to extreme policy measures is a cause for concern and a potential reason to disinvest. India has historically traded at a premium to other emerging markets because of its relatively stable politics, but this calls that premium into question.

This is an important point when comparing political risk in emerging markets to political risk in developed markets: Political risk is expected in emerging markets and is reflected in lower valuations. The stock markets of the US, UK and Europe have continued to rise in spite of the political environment. Investors in emerging markets know to anticipate political problems and it is factored into market prices. We would argue that developed market valuations do not currently reflect political uncertainty.

There are areas where we believe political risk is too high and valuations are not sufficiently cheap. This is the reason we are not significantly exposed to Turkey, Russia or South Africa. In each case, domestic politics are still intrusive and weaken the investment case.

In contrast, we have been increasing our weight in Latin America, which is one of the only regions that has become more politically and economically orthodox. Countries such as Chile, Peru and Columbia have been implementing an increasingly conventional economic model, which is likely to foster long term growth.

Politics can influence financial markets, but as investors, we need to be careful not to try and predict the outcome of political events, but to be well-prepared for all eventualities.