On today’s Macroeconomic Briefing we highlight research on the geopolitics theme, looking at how political risk can be more objectively assessed and measured, and how the relationships/correlations between developed and emerging markets are changing. We lead off with Oxford Analytica, a firm that has developed tools to quantify political risk, and who have just published their quarterly political risk report, where they say the miscalculation of political risk means companies and investors are avoiding net-positive investments in higher-risk markets. The risks in developed markets need to be watched more closely, and the report shows increasing shifts in the US, UK, and Spain. It’s an interesting theme picked up on my ECR Research, who look at the fragmentation of liberal democracy and and the rise of populism and argue that some nations in the West needs assessed as if they’re EM countries when it comes to political risk. We also highlight research in some of these emerging economies where risk is seen to be rising by Oxford Analytica’s measures, such as Brazil, Mexico, and where developed market risks are seen to be the highest, such as Israel and Italy.
Substantive's Top Themes - Best of the Broker Notes
1. Italy's warming relations with China and Russia
Italy is crucial regarding the future of the Eurozone, given its debt, but is something of the 'difficult child'; unwilling to be defined exclusively by Western powers, writes OM Research. Indeed there is growing evidence that Italy is seeking influence with powers outside Europe; China and Russia. OM argues that Italy’s trading connections with Russia and China are prized and, from an SME goods export perspective, they are paying-off. OM Research interprets these growing relationships as growing evidence that the current government is using every opportunity to put-back the inevitable day where the nation is forced to reform its economy, something that has proved intractable for generation after generation.
2. Rich countries increasingly resembling emerging markets
Trump's attacks on the Fed, the Brexit soap opera, the gains of the populists in various European states show that clearly the political risks in the West have considerably increased. The question is will investors have to assess the rich countries more like the emerging markets when it comes to political developments that could undermine growth and increase the risk premium for the world's most developed economies? That question is discussed by ECR Research in a recent report. In the past investors distinguished political risk between the rich countries and the emerging markets by focussing on the functioning, stability, and reliability of (and confidence in) institutions such as parliament, the courts, the police force, and so on. Therefore, the political risks in the rich countries were, safely assumed, to stay within fairly narrowly defined bandwidths: some more tax cuts here, somewhat wider deficits there, slightly more support for free trade, etcetera. Comparatively, there tended to be far more fluctuations in the emerging economies due to nationalisations, expropriations, sudden exchange rate changes, etcetera. Not to mention revolutions and (civil) wars. But these assumptions are being challenged now, and the political oscillations and the bandwidths that delineate policies and politics are gaining momentum in the West, say ECR. For instance, the seizure of power by populist movements in countries such as Italy, Donald Trump's election, Brexit, and the fragmentation of the political landscape in many Western democracies point to a growing (potential) impact on the underlying financial, economic, and market conditions of political developments.
3. Brazil's pension reform hits road blocks, curtailing growth prospects
Eurasia Group have been tracking Brazil's pension reform process closely in recent weeks, and it's not going well, they say. According to pollster Datafolha, 51% of the public opposes President Jair Bolsonaro’s pension reform proposal, while 41% supports it. Eurasia say public support is vital for the legislation, and because Bolsonaro is not promising executive appointments and government spending in exchange for votes, thus lawmakers will be even more sensitive to public opinion trends, Eurasia argue. Though a public split on the merits of Bolsonaro’s proposal is still broadly favourable for its prospects, the odds of failure (currently at 30% according to Eurasia) would increase if the public turns more negative. In recent weeks, Eurasia have pointed to a growing skepticism among lawmakers that this will be approved on April 17 as planned, and if these pension reform talks extend throughout the whole year then there is bigger risk of public opinion turning more negative against the president or the pensions overhaul. These reforms are critically important for Brazil's economy, and the future growth path. See this piece here, by Bloomberg that sets out why they matter.
4. Mexico; Evidence of public finance risks
Mexico’s public finance results remained unfavourable through the first two months of 2019, confirming that officials have very little financial room in which to operate, much less in which to fulfil the new government’s targets on the level of such central issues as expanding investment, increasing social spending, and stimulating economic growth, write Global Source Partners. Moreover, it appears this administration will be especially slow to gear up public spending and even to begin efficiently collecting taxes, GSP's report says. Many of these problems stem from the fact that this is a novice government, according to GSP. It's a whole new generation of officials and even lower-level public servants after the expertise of the thousands of employees does not exist after being purged from government payrolls. It's a steep learning curve, which has not been helped by the erratic and contradictory signals the government regularly serves up, as well as adverse external factors including the uncertain fate of the T-MEC/USMCA, GSP goes on to say. Furthermore, Pemex’s financial and operational health remains fragile, and GSP's analysts have yet to see anything that might bring any improvement on that front. This is especially concerning because of the direct contagion effect the company poses to public finance and Mexico credit risk. All of these concerns are underscored by the 2020 General Economic Policy Preliminary Guidelines the administration unveiled this past week, which reaffirm deficit spending limits and debt targets, but project a revenue shortfall, conclude in the report.
5. Emerging market opportunities go begging as geopolitical risk overstated
Miscalculation of political risk means companies and investors are avoiding net positive investments in higher-risk markets, Oxford Analytica argues in its latest quarterly VAPOR Country Risk Ratings report, which effectively can be used as a VAR tool for political risk, both in developed and emerging markets. Standard methods for measuring political risk (commonly sovereign spreads as a proxy) overestimate risk by 2-4%, the report argues. The emerging market benchmark is currently showing positive, with Turkey having a cautiously upgraded outlook. Frontier markets are downgraded to negative, dragged down by Argentina, though green shoots are visible in Vietnam and Sri Lanka. Risks, of course, remain. Gas, water and power utilities are now the most politically exposed industries globally, with the low growth environment increasing the chances of unilateral price freezes which may breach previous guarantees to investors. Still, with correct pricing, FDI inflows into emerging markets could have been $3.6 billion greater, the report argues.
6. Aramco bond issue will help shift narrative on Saudi Arabia
The state-owned energy giant is finalizing a USD 12 billion issuance that has received a record-breaking USD 100 billion in orders. The issuance represents a key juncture in Saudi Arabia’s changing political and economic narrative, argue Eurasia Group. From an economic standpoint, the strong demand for longer-dated paper signals a belief that Aramco and its energy business will remain highly relevant for decades to come, while politically, Crown Prince Mohammed bin Salman will benefit immensely from the success of the deal, Eurasia say. It will shift attention away from the Khashoggi affair and demonstrate beyond a reasonable doubt that investors are still interested in the kingdom, its economy, and its energy giant. Second, there is now solid proof that the young royal’s push for greater transparency of Aramco and its activities was appropriate. Ayham Kamel, Eurasia's Practice Head for Middle East and North Africa hosted a conference call last Friday, where he will discussed the deal and the implications in greater detail. Click below to enquire about access to the recording.
7. Middle East peace process remains on track despite Netanyahu's against the odds win
Benjamin Netanyahu has stunned the world - he has won the general elections in Israel by a larger margin than expected, an outcome that resembles something similar to the 2016 US elections, writes Christian Takushi from Geopolitical Economics. Seldom before has Israeli media launched such a campaign against a candidate. It backfired, he says. Likud supporters stood their ground, while the traditional opposition parties suffered heavy losses. What are the implications for the Middle East peace process? While most analysts are saying this outcome is a massive blow to the already moribund Peace Process, Takushi disagrees. He sees global security shifts forcing Israel and Palestine to compromise down the road. Therefore Takushi keeps his assessment (the same since late 2017) that a Peace Deal is now more likely than over the past two decades. A conflict or a war as a trigger for such a peace deal cannot be ruled out however. Takushi has also developed analysis on UK and the EU-China relations, which he will publish in upcoming reports.