Forget Korea, or the Middle East. Christopher Smart says gradual shifts in international global institutions can be far more consequential for investor behaviour, and fundamental realignments are taking place

By Christopher Smart*

One of the great mysteries of today’s global markets is their irrepressible enthusiasm, even as the world around them appears on the verge of chaos or collapse.

And yet, investors may be more rational than they appear when it comes to pricing in political risks.

If investing is foremost about discounting future cash flows, it’s important to focus precisely on what will and will not affect those calculations.

The potential crises that may be most dramatic or violent are, ironically, the ones that the market has the easiest time looking through.

Far more dangerous are gradual shifts in international global institutions that upend expectations about how key players will behave. Such shifts may emerge only slowly, but they can fundamentally change the calculus for pricing in risks and potential returns.

Today’s market is easy to explain in terms of fundamental factors: earnings are growing, inflation has been kept at bay, and the global economy appears to be experiencing a broad, synchronized expansion. In October, the International Monetary Fund updated its global outlook to predict that only a handful of small countries will suffer a recession next year. And while the major central banks are planning, or have already begun, to tighten monetary policy, interest rates will remain low for now.

Political crises, however sensational they may be, are not likely to change investors’ economic calculus. Even after the greatest calamities of the twentieth century, markets bounced back fairly quickly. After Japan’s attack on Pearl Harbor, US stock markets fell by 10%, but recovered within six weeks. Similarly, after the terrorist attacks of September 11, 2001, US stocks dropped nearly 12%, but bounced back in a month. After the assassination of President John F. Kennedy, stock prices fell less than 3%, and recovered the next day.

Yes, each political crisis is different. But through most of them, veteran emerging-markets investor Jens Nystedt notes, market participants can count on a response from policymakers. Central banks and finance ministries will almost always rush to offset rising risk premia by adjusting interest rates or fiscal policies, and investors bid assets back to their pre-crisis values.

Today, a conflict with North Korea over its nuclear and missile programs tops most lists of potential crises. Open warfare or a nuclear incident on the Korean Peninsula would trigger a humanitarian disaster, interrupt trade with South Korea – the world’s 13th largest economy – and send political shockwaves around the world. And yet such a disaster would most likely be brief, and its outcome would be clear almost immediately. The world’s major powers would remain more or less aligned, and future cash flows on most investments would continue undisturbed.

The same can be said of Saudi Arabia, where Crown Prince Mohammed bin Salman just purged the government and security apparatus to consolidate his power. Even if a sudden upheaval in the Kingdom were to transform the balance of power in the Middle East, the country would still want to maintain its exports. And if there were an interruption in global oil flows, it would be cushioned by competing producers and new technologies.

Similarly, a full-scale political or economic collapse in Venezuela would have serious regional implications, and might result in an even deeper humanitarian crisis there. But it would most likely not have any broader, much less systemic, impact on energy and financial markets.

Such scenarios are often in the headlines, so their occurrence is less likely to come as a surprise. But even when a crisis, like a cyber attack or an epidemic, erupts unexpectedly, the ensuing market disruption usually lasts only as long as it takes for investors to reassess discount rates and future profit streams.

By contrast, changes in broadly shared economic assumptions are far more likely to trigger a sell-off, by prompting investors to reassess the likelihood of actually realizing projected cash flows. There might be a dawning awareness among investors that growth rates are slowing, or that central banks have missed the emergence of inflation once again. Or the change might come more suddenly, with, say, the discovery of large pockets of toxic loans that are unlikely to be repaid.

As emerging-market investors well know, political changes can affect economic assumptions. But, again, the risk stems less from unpredictable shocks than from the slow erosion of institutions that investors trust to make an uncertain world more predictable.

For example, investors in Turkey know that the country’s turn away from democracy has distanced it from Europe and introduced new risks for future returns. On the other hand, in Brazil, despite an ongoing corruption scandal that has toppled one president and could topple another, investors recognize that the country’s institutions are working – albeit in their own cumbersome way – and they have priced risks accordingly.

The greatest political risk to global markets today, then, is that the key players shaping investor expectations undergo a fundamental realignment. Most concerning of all is the United States, which is now seeking to carve out a new global role for itself under President Donald Trump.

By withdrawing from international agreements and trying to renegotiate existing trade deals, the US has already become less predictable. Looking ahead, if Trump and future US leaders continue to engage with other countries through zero-sum transactions rather than cooperative institution-building, the world will be unable to muster a joint response to the next period of global market turmoil.

Ultimately, a less reliable US will require a higher discount rate almost everywhere. Unless other economic cycles intervene before investors’ expectations shift, that will be the end of the current market boom.


Christopher Smart is a senior fellow at the Carnegie Endowment for International Peace and the Mossavar-Rahmani Center for Business at Harvard University’s Kennedy School of Government. He was a special assistant to the US president for International Economics, Trade, and Investment (2013-2015) and Deputy Assistant Secretary of the Treasury for Europe and Eurasia (2009-13). Copyright: Project Syndicate, 2017, published here with permission.

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4 Comments

OK so that presumes “central banks & finance ministries will adjust interest rates or fiscal policies”
The writer says nothing of the current situation where the central banks & finance ministries simply printed their way through the GFC and thus expanded the worlds total debt exponentially
What magic is left for the central banks today after all their QEs if GFC2 is triggered by some event ?
The FED is timid about even slightly raising interest rates
Investors have bid up all asset classes and borrowed even more than pre GFC
I’d love the writer to address how effective he thinks the GFC was addressed by the FED
and what casualties they’ll be when the biggest debt bubble in history bursts ?

"One of the great mysteries of today’s global markets is their irrepressible enthusiasm, even as the world around them appears on the verge of chaos or collapse."
- This is no mystery at all. While analysts and economists do all their A+B=C equations in the pretence that we live in a world with linear outcomes, the real world and people are behaving as follows:
1) More and more intelligent investors/funds are slowly realising that govt bonds are not safe, and many will default in the next 15-20yrs;
2) Intelligent investors realise that bank deposits are anything but safe for obvious reasons;
3) Property is arguably at a peak and will likely incur greater holding costs (property taxes, wealth taxes, etc) going forward;
4) In light of the above 3 points, that doesn't leave a lot of investment options for investors/funds outside of equities and corporate bonds.
So, it's not a case of "enthusiasm" or "irrational exuberance" at all...it is simply about no other options on the table. In fact, the equity rally of the past 8-9yrs is probably one of the most hated rallies in history - just look to the MSM for evidence of that. In addition, the retail "mum and dad" investors are barely in the market!
However, no doubt all the clever analysts and economists will continue advising to short the market and there will be plenty of people who get burned on the way up...

Ludwig.

'In addition, the retail "mum and dad" investors are barely in the market!' .....
suggest that might be changing. NZX this week reported an uptick in trading activity. No doubt some from the tsunami of cash being generated by retirement funds and offshore investors rebalancing but I notice an increase in media articles and discussions about direct investment in equities and suspect that political intervention in the housing market is beginning to redirect investors.

All great comments
There is no safe answer and those who think they’re doing well in the sharemarket today are parking their futures in an unwise ponzi of exuberant sentiment Yes mom & pop latecomers will be burnt in the downturn

The banks are creating all sorts of new investments for the scared public
One giant bank here has another new product guaranteeing capital and a tiny return yet you’re in the sharemarket
The problem for investors who invest in “safe” products such as these and those who short the market is they all make a presumption they will be protected and rewarded
After GFC2 there won’t be the ability to QE like before without worsening the financial destruction.
The winding back of all the QEs is uncharted waters hence the FEDs timid unwinding strategy