Politics and Investing (updated 22 Feb 99)

What effects does politics have on economics? How can investors analyze political risks - often across a range of different national political environments - and assess their likely effects on equity returns? After all, financial markets are generally thought to lead economics and economics leads politics (see ECONOMIC FORECASTING). So there is a direct connection through leads and lags.

One way to think about a global portfolio is as follows. The equity prices of individual firms are in part determined by the past and prospective indicators of their corporate performance, and in part by the nature of the markets and industries in which they compete. But the last and often most significant determinant of share values are overall movements of the stock markets on which they are listed (although it should be noted that recent convergence of the overmarket returns has been attributed to common global banking influence).

These rises and falls are, in turn, influenced by three factors: first, major financial events, notably changes in the level of interest rates; second, major fiscal events, essentially the shifting patterns of revenues, spending and borrowing reflected in government budgets; and third, major political events that could have dramatic effects on both financial and fiscal matters and through them on the future course of the national economy.

For the stock markets of the industrialized and democratic world, often the key political issue is the electoral cycle and how this might affect the business cycle. For example, it has been known for incumbent governments to engineer a boom just prior to an election, and such expansionary policies, aimed at reducing unemployment and taxes, may boost equity markets. After an election, though, as their inflationary consequences kick in and growth turns into recession, they are likely to be followed by contractionary policies, which will generally dampen market enthusiasm.

For example, there is a well-documented 'presidential cycle' in US equity markets, which highlights favorable market forces in the fourth year of a presidential term. The suggestion is that political powers favor expansionary policies to attract voters. And then, after the election, regardless of the outcome, markets tend to retrench to compensate for the politically induced pre-election policy.

Political business cycle effects may be tempered by the political color and commitments of incumbent or incoming governments. For example, governing parties of the left have traditionally been regarded as less fiscally responsible than those of the right, and hence less positive for the markets - though there is evidence to the contrary in the United States, where markets have done better under Democratic administrations. What is more, with so many left of center political parties practicing or at least promising fiscal conservatism, perhaps a better measure of market prospects is whether a new government - whatever its persuasion - has a working majority, a substantial period in office and a credible reputation on the economy.

Another politically-determined influence on a country's economic prospects, which appears to be increasingly important and may counter the electoral cycle, is the degree of independence of the central bank. These institutions control national monetary policy, primarily through interest rates, and the theory is that the greater their independence, the less room governments have to engineer booms. Recent research seems to confirm that more independent monetary authorities bring about lower inflation, lower interest rates and higher growth. Indeed, the US Federal Reserve now seems to be taking on even bigger chores, such as international monetary coordination, business cycle management and 'jawboning'.

Guru of political analysis: Ed Yardeni

Most investment economists are also political analysts. Investors like to visit political leaders to learn the course of policy and how it might influence their holdings. Especially in emerging markets there is a dance of politicians looking for money from advanced countries and investors looking for opportunities for gain greater than in their home markets. And visiting well-publicized government leaders to exchange views on macro-issues is impressive content for reports to committees and clients.

Ed Yardeni, chief economist of Deutsche Bank, may be one of the best in combining economics and politics. His website contains some of the most valuable economic data and his weekly audio telephone meeting for clients is an important visit for people who want to observe a blend of the two disciplines.

Dr Ed, as he styles himself, could be labeled an omnibus economist. Such analysts examine a range of influences on prices, culture, cycles, history, politics and even exogenous events. For example, Dr Ed has been carefully studying the likely economic outcomes of Y2K. He believes that four decade old COBOL programming buried deep in computer code and which allocates only two digits for the year 2000 will produce a major economic disruption. His economic peers, who study past economic data for trends and turns, may be skeptical of the value he sees in being interested in an outside factor that might already be anticipated correctly by markets.

Counterpoint

Politics is usually thought to influence economic outcomes. But is it more often the other way around, with markets leading politics? After all, market declines in Asia from the summer of 1997 preceded political upheavals, and market stability in the United States in the period up until the second half of 1998 seemed to buttress political stability when events might have undermined it.

Economics writer David Warsh of the Boston Globe argues that 'good markets make for lackluster politics - and vice versa.' Asking why voter interest in US presidential and mid-term congressional elections has declined so dramatically since the early 1970s, he concludes that 'quite simply, economics took over from foreign policy. The nation turned away from the great public issues of the Cold War to pursue private prosperity instead. There was a great inflation in the 1970s; an asset boom in the 1980s; a more widely shared prosperity in the 1990s. More people tended their portfolios. Fewer voted.'

In emerging markets, there are usually greater political risks than those threatened by elections or democratic changes of government. Unrest seems to be a concomitant of economic outcomes below expectations. And while it is true that western-style democracies are not a requirement for prosperity and economic growth, the brief history of most of these markets' international prominence makes investors understandably cautious if willing to exchange greater risk for potentially much higher rewards.

Emerging markets do tend to be less covariant with one another than developed markets: a basket of well-diversified emerging markets, each potentially riskier than its developed market counterpart, may, on aggregate, be less risky. But these covariances can be very unstable. For example, in 1998, emerging markets declined and bond yields increased because of the sense that the two asset classes shared a common need for funds while liquidity was decreasing. Earlier historical analysis did not illuminate these parallel influences.

Political risks in emerging markets include the risk of government default in the case of bonds; the risks of nationalization, stock market manipulation, and unfavorable or inadequate regulatory environments in the case of equities; and the risks of expropriation of assets, exchange controls and other anti-foreign investor legislation, which make it impossible to get capital, profits, interest or dividends out of the country. And such risks are not always limited to emerging markets: a number of countries, the United States among them, have frozen the assets of political enemies, such as Libya, Cuba, Iraq and Iran.

Guru response

Ed Yardeni comments: 'I guess I am an old-fashioned political economist. Prior to Keynesian economics, the subject was called political economy. It is unfortunate that the two have been split. It is also too bad that economics was split again into micro- and macroeconomics. Adam Smith carefully explained the advantages of the division of labor. However, the tendency to specialize in narrower and narrower areas of research in politics and economics has been a definite disadvantage. Economists are smarter and smarter about fewer and fewer subjects. They tend to focus only on their narrow field of interest. That makes many of them very uninteresting, and irrelevant.'

Where next?

A number of organizations like the Economist Intelligence Unit offer subscribers a useful regular summary of national credit risk ratings of emerging markets based on economic and political factors. Looking at a similar sample of emerging markets, the Heritage Foundation, a conservative US consultancy, produces an 'index of global economic freedom' in association with the Wall Street Journal. This ranks countries on the degrees to which their governments intervene to restrict economic relations between individuals. It covers the gamut of economic affairs, including trade policy, taxation, monetary policy, foreign investment rules, regulation policy, the size of the black market, and the extent of wage and price controls. In the 1998 index, Hong Kong came out top as the most 'free' while North Korea was at the bottom.

While equity market predictions based on economic and political information of this kind will remain fraught with difficulties, these indexes do at least offer a crumb of quantifiable hope to this vital aspect of the game of playing the world's equity markets. Political risks are by no means as easily assessed as a corporate balance sheet, but they should never be forgotten.

As for the economics profession, perhaps the pendulum is starting to swing back the other way towards political economy with the 'econ tribe' becoming a little more in touch with the real world and trying occasionally to look at the big picture - certainly once they have jumped through the hoops, such as publishing in the big journals, getting tenure and showing they can do the high-tech theoretical wizardry.

Read on

In print

David Warsh, Economic Principals: Masters and Mavericks of Modern Economics

Online

www.boston.com/globe/columns/warsh/ - David Warsh's column in the Boston Globe
www.eiu.com - the Economist Intelligence Unit
www.heritage.org/index/ - the Heritage Foundation
www. yardeni.com - Ed Yardeni's website