One week / one topic: Democracy cuts both ways

What happened?

Following recent elections in India, Mexico and South Africa – together accounting for ~20% of world population – local assets experienced notable volatility.

While ‘emerging markets’ (EM) is a catch-all term encompassing very different countries, investors in the space have historically argued that superior returns should follow as these democracies become more mature – bringing about an increasingly established rule of law, the rise of a local middle class and secure property rights.

This past week, they were reminded that indeed there is no free lunch – and that EM volatility can spike quickly, especially around elections.

• Modi won a third consecutive term in India, yet with less margin than recent polls had suggested.

  After the immediate sharp move lower, both Indian equities (white) and the rupee (blue) however quickly recouped pre-election levels. Investors still believe in the powerful ‘country of the future’ narrative here.

• In Mexico, Sheinbaum’s resounding victory brought her party close to the 'supermajority' required to pass constitutional reforms.

  The potential for anti-capitalist measures spooked markets, leading to a steep 7% drop for local equities on Monday (only partially recouped since) while the Peso remains 8.5% lower – which is a very notable weekly move.

• Finally, the ANC party in South Africa lost its majority for the first time since the country emerged from apartheid.

  Local equities (blue) are currently 3% lower, while the Rand (white) has lost 3.5% compared to pre-election levels.

In short order, investors were reminded of the fact that:

1. Elections matter and tend to be extremely hard to forecast;

2. The financial impact of political outcomes is essentially unknowable in advance. (Remember the 2016 US elections?)

Importantly, at least in one regard, ‘emerging markets’ currently look no different from their G7 counterparts – following the Covid-induced fiscal largesse, voters continue to want more spending now.

Therefore, ‘asset owners-friendly’ policy announcements look unlikely anytime soon. But should investors conclude anything different from recent EM developments, and accordingly reprice the risk of local assets?

Our observations

• Fundamentals: Tautologically, the political backdrop has indeed changed across all three countries. Strategic investors can perhaps maintain the long view here, but recent developments should at least serve as a powerful reminder of the more pronounced ‘buyers beware’ aspect of EM investments.

• Price action: Beyond the immediate volatility – which can also be observed across increasingly algo-driven developed markets as well – we were reminded of how much less liquid EMs remain, and how difficult it can be to shift large positions here amid fast price action.

• Investor beliefs: At the moment, investors seem fixated on trying to divine the future of US rates – or rapt with Nvidia-related ‘Jensanity’ – so that overlooked opportunities in EM could indeed arise… (see recent note on Brazil)

So what?

While we did not own any local equities going into the elections, across portfolios we retain strategic long positions in a basket of well-diversified EM local currency government bonds.

The sovereign credit risk of India, Mexico and South Africa’s dollar-denominated bonds looks unaffected by recent election results, and we’d agree with this assessment – there is no revolution on the horizon.

We therefore maintain conviction in our EM local currency bonds positions, which also act as a complement to our holdings in short-maturity, high quality HY bonds – especially in terms of income generation.

While long-term returns have been remarkably similar (below), there have indeed been compelling opportunities to switch over multi-year periods.

Yet – in the absence of a clear steer from valuations – we keep prioritizing diversification across our ‘risky credit’ positions by maintaining similarly-sized positions in both.