Why markets hate revolutions

Australian Financial Review – Smart Money, March 2011

Revolutions give power to ordinary people. They make for great TV: what is more enthralling than a country finding its popular voice?

But markets hate them.

The scenes playing out in the Middle East right now are truly momentous and will change the shape of the countries affected forever. At the time of writing, Tunisians and Egyptians had brought down their governments, and Libyans were attempting to bring down theirs in a situation so violent it borders on civil war. In Bahrain, Yemen, Iran and Jordan, protests of varying magnitude (met with state responses of equally varying magnitude) have taken place. And even in places where major protests have not been launched, many governments have set about modest reform in the hope of stopping the same thing happening there, notably with an uncharacteristic redistribution of state wealth in Saudi Arabia.

A remarkable time. But from the point of view of the emerging markets investor, it’s not all good news, for several reasons.

Firstly, a shift to democracy is almost universally seen as a good thing for a country’s population, and ultimately (though countries like China would of course disagree with this) for the country’s overall prosperity.  But it doesn’t happen straight away. Look at Indonesia: it was, under Suharto, quite the emerging market darling, a magnet for foreign investments into power and infrastructure despite being far from democratic. The people got their way, and Indonesia is hailed today as a model for how democracy can work; the economy is buoyant and the market soaring. But it took a decade of pain and underperformance for that to happen. It’s reasonable to assume that, while what’s happened in Egypt is good news for Egyptians, it could take just as long for that to manifest itself in robust economic performance.

The truth is, there are countries in the world that the west likes trading with and investing in precisely because there’s no spectre of a change of government. Singapore is the classic example: since the government isn’t going to change in this generation, people know there’s no threat to its free-market environment, no danger of an unexpected change in the rules of engagement. To varying degrees, the autocracy of China, the United Arab Emirates (which is home to Dubai and Abu Dhabi) and Vietnam have suited foreign investors just fine. Look what happened when Malaysia, after 40 years of unquestioned one-party rule, finally developed a credible opposition party which won one third of the seats in a general election two years ago: foreign capital fled the country and the markets sank. Markets hate change.

One might argue that developments in the Middle East affect nobody’s portfolio here in Australia. Superficially, that’s probably true. A handful of emerging market funds might hold a big Egyptian stock like Orascom Telecom, but generally the Middle East occupies a tiny part of emerging markets portfolios, which are overwhelmingly tilted towards Asia, then Latin America, then Eastern Europe, then South Africa, with the Middle East and the rest of Africa last. In particular, Gulf markets such as Saudi Arabia, Kuwait and the UAE don’t feature in the MSCI Emerging Markets index, and as a consequence most international fund managers don’t feel any need to monitor those markets or invest in them.

But the problem is, global capital behaves in odd ways, and has a frustrating habit of treating all emerging markets as a single bloc – when something unpredictable happens in one, it tends to impact sentiment to all of these far-flung countries. That’s patently absurd, but it is exactly what happens, and it’s happening again now, with money leaving Asia – which certainly is a significant part of Australian investments – rather than just the Middle East. A Bank of America Merrill Lynch survey in March found that allocations to emerging market equities faced their sharpest ever one-month fall in February of this year, with only 5% of global fund managers now overweight emerging market equities compared to 43% in January. And according to the fund flow tracking group EPFR Global, in the year to February 28, US$6 billion of institutional money left the Asia ex-Japan equity markets, and US$1.5 billion left China country funds alone. Melbourne-based IG Markets analyst Ben Potter notes “a resumption of the ‘risk-off’ trade, with money flowing from riskier assets and currencies into perceived safe havens.”

This isn’t all about Middle East tension: other problems have been a perceived overvaluing in emerging market equity at the start of the year, concerns about inflation in Asia and the measures central banks might use to deal with it, and in particular rising food prices. Also relevant is the fact that many managers think developed markets, particularly the US, are finally ready to grow again and present a better risk-return trade-off than emerging markets. “Asia’s markets have had a dismal start to 2011, with equity, bond and even currency markets barely holding their heads above water,” says John Woods, chief Asia strategist at Citi Private Bank. “A widely held view that higher food prices – and now higher oil prices, caused by unrest in the Middle East and North Africa region – will elicit a tighter fiscal and monetary response from policymakers has provoked a sharp movement of institutional investment money out of the region.”

“The severity of the recent correction suggests investors are concerned – even convinced – that higher food and energy prices could upset Asia’s growth and further stoke inflation,” Woods says. “This is in sharp contrast to last year, when they were more positive about growth than they were concerned about price pressures or value.”

Another problem is that events in the Middle East clearly have an impact on the oil price, which has knock-on effects of its own. “We think what is happening in the MENA [Middle East and North Africa] region matters and that markets are increasingly vulnerable,” says Wood’s colleague Richard Cookson, global chief investment officer. “Not because higher oil prices are an inflation threat in the longer term, but because they threaten growth.” Correspondingly Citi Private Bank is reducing risk in its portfolios, and was already underweight Asian equities even before the unrest in the Middle East.

Similarly, Nomura analyst Rob Subbaraman argues that fuel prices could push food prices higher, which is also bad for Asia. “If the flare-up in MENA intensifies, the likely further run-up in commodity prices could impart a sinister supply-side shock to much of Asia, hurting growth and exposing vulnerabilities,” he says, highlighting India, the Philippines and Vietnam. Asia doesn’t export all that much to the MENA region: India has the highest exposure, with 21.2% of merchandise exports in 2009 going there, according to Nomura, but most are at around 5%. “The far more important channel through which Asia’s economies would be affected is a continued surge in oil prices and, quite plausibly, food prices too,” says Subbaraman. “Given that spreading social unrest in MENA was triggered partly by high food prices, governments around the world have more incentive to shield the poor by controlling food prices, providing food subsidies, restricting trade and stockpiling.” This tends to exacerbate supply-demand imbalances; within Asia, he suggests Hong Kong, Korea, the Philippines, Taiwan, Singapore, India, Japan and China are all exposed to worsening trade positions from further rises in food and energy prices.

So what does all this mean for investors? Mainly, that just because you don’t hold any Middle Eastern stocks through your managed funds or your super, it doesn’t automatically mean that you’re not exposed. Emerging markets can have the best story in the world – and, over the long run, they probably do – but if global capital decides to be fickle and flee to more predictable developed markets, then those emerging market investments are going to suffer accordingly no matter what their merits.

Box: Emerging markets funds in Australia

Fund researcher Morningstar tracks 49 emerging market funds sold in Australia, although many of them are structural variations of the same product, such as a retail and a wholesale version of a fund.

Some of them have attracted considerable assets in Australia: Morningstar logs the biggest, the Lazard Emerging Markets Fund, as having A$1.241 billion under management. Other large funds include Colonial First State’s emerging markets fund, an index fund from Vanguard, and emerging funds from Arrowstreet, Aberdeen, GMO and Dimensional. Several other of the most famous names in emerging market investment, most notably Templeton and Schroders, have their products available here without yet having attracted as many assets.

In fact, many Australians have emerging market exposure through a different model: Asia-only funds. Morningstar tracks a further 40 such investment options in Australia, including by far the biggest of all: the Platinum Asia fund, from home-grown Platinum Asset Management, which has A$3.63 billion under management. Funds from Aberdeen and BT have also attracted considerable inflows. This category includes a handful of country-specific funds, focusing on China and India.

Middle East exposure in these funds is typically minimal. When most fund managers talk about Asia, they tend to mean an area going as far west as India and sometimes Pakistan, but not the Middle Eastern markets – so they don’t appear at all in the Asia funds. In the broader emerging market funds, Egypt – which has the oldest and deepest stock market in the region – is the most common name to appear: in the Lazard fund, for example, it accounted for 2.4% of the portfolio in January, although that represented quite an overweight from its 0.4% weighting in the MSCI Emerging Markets index. Turkey typically accounts for a bigger chunk (6.1% in the Lazard fund) but it tends not to be considered a Middle Eastern market, and instead something of a middle ground between that region and Europe.