2018 politics in emerging markets: risks or opportunities?

By Stéphanie de Torquat, macro strategist

The past two years have been marked by political risk in developed economies, with Brexit in June 2016, followed by the election of Donald Trump in November, and the rise of eurosceptic parties throughout 2017, which culminated in Marine le Pen making it to the second round of the French presidential election.

The rest of 2018 should be calmer in developed economies despite ongoing discussions around Brexit and the risk of a protracted period of uncertainty in Italy. However, the political agenda in emerging economies is relatively busy, and it is worth assessing the potential impact of the various votes across the regions.

Colombia

Parliamentary elections as soon as next week (March 11), followed by presidential elections in the spring (May 27).

Since signing a peace agreement with the government in September 2016, the Revolutionary Armed Forces of Colombia (FARC) has created a legal political party. However, the situation has not fully stabilised, and one of the main challenges of the next administration will be to ensure that this agreement is respected. The government is also in discussions with the country’s second rebel group, the National Liberation Army (ELN), and reports suggest that those negotiations remain tense.

Deep divisions within Congress, as well as across the main political parties, is a key source of risk going into the legislative elections. This could lead to a situation in which no party or coalition secures an overall victory, therefore potentially stalling negotiations concerning the ELN and the FARC.

With regards to the presidential elections, the current president, Juan Manuel Santos, cannot run for an additional term and the next president will need strong shoulders as they will inherit a still unstable political, economic and social situation.

From a macroeconomic standpoint, things are going in the right direction.

Indeed, the rise in the price of oil – which is the country’s main export – has led to a significant improvement in both the trade balance and the twin deficit (Chart 1). Meanwhile, it has also triggered a virtuous cycle of disinflation, lower rates and growth recovery. Given our year-end price target of USD 64/barrel for Brent, this momentum should hold; meanwhile any futher development in the situation with the FARC and the ELN will be dependent on which party wins the election.

Russia

Presidential elections on March 18.

There is little question over the the outcome of this election. That said, it will be interesting to see how convincining Vladimir Putin’s victory proves to be given that his administration has set itself a goal of ‘70/70’ (i.e. to obtain 70% of the vote, with 70% participation).

The real political risk in Russia lies at the international level as US sanctions could intensify before November’s mid-terms in response to allegations of Russian meddling in the 2016 US presidential vote.

As in Colombia, Russia’s economic cycle is highly dependent on oil (with a correlation of close to 1 between the ruble and Brent prices), which allowed the central bank to initiate a rate-cutting cycle. That said, the bank has remained cautious and real rates are still relatively high (Chart 2). This means that the easing cycle is probably not over and Russian assets could offer interesting investment opportunities – particularly since fundamentals are sound (a current account surplus, a budget deficit under control, a resumption of foreign direct investment, despite sanctions, and high levels of reserves that cover more than 100% of the external debt in foreign currency). In addition, from a cyclical standpoint, its hosting of the FIFA World Cup this year could help attract new investors.

That said, Russia faces continued short-term risks (US sanctions), and longer-term challenges (the ageing population and the need for structural reforms to diversify sources of revenue away from oil).

Hungary

There is no political risk in Hungary – but that is not necessarily good news.

The Fidesz government is almost sure to win the parliamentary elections on April 8, which will embolden Prime Minister Viktor Orban in his anti-European Union rhetoric. Indeed, Orban has been using the migrant crisis and Islamic terrorism in Europe to assert his popularity by describing himself as a protector of Hungarian culture. He also tightened his grip on the Medias and introduced new laws to curb freedom of speech and restrict the activities of foreign non-government organisations.

For these reasons, the European Commission is increasingly likely to propose sanctions by  triggering article 7 of the Lisbon Treaty (as it did for Poland). With Poland and Hungary protecting each other, nothing tangible is likely to result from this, but this could nonetheless lead to a reduction of EU funding from 2021. Ultimately, this would weaken the country’s position within the EU and negatively impact its long-term growth potential.

Economically, the dynamic is strong, but overheating risks are mounting.

Indeed, instead of using current solid growth as an opportunity to reduce its relatively high public debt, authorities are undertaking fiscal and monetary stimulus. At this stage, inflationary pressures remain limited, but with a rapidly shrinking current account surplus and strong wage pressures, we would not be surprised to see inflation accelerate (Chart 3).

Malaysia

The date of parlimenary elections in Malaysia has yet to be confirmed, however, they must be held before August 24.

The current coalition, led by Prime Minister Najib Razak, will likely stay in power despite the 2016 1MDB financial scandal (in which  USD 3.5 billion was found to have been diverted from the 1MDB Malaysian sovereign wealth fund. USD 681 million allegedly went to Najib).

In addition, Najib’s former mentor, Mahathir Mohamad, has decided to run in the opposition in order to destabilise him. Therefore, this election could witness an intensification of racial rhetoric and social tensions.

That said, there is little cause for concern, in our view, particularly since Malaysia’s economic fundamentals are solid. Indeed, the country is growing strongly given its upper/middle-income status and monetary policy is remarkably stable (Chart 4). It is true that external and private debts are relatively high, but the current account is in surplus and the budget deficit under control, while the country is also a net beneficiary of the oil recovery.

India

India’s 29 states elect their own legislative assembly every five years. State elections are more important than they seem.

This year, eight states hold elections of which three are particularly important because a) they are entitled to a large number of seats in the upper house of parliament and b) they will help to gauge Prime Minister Narendra Modi’s popularity ahead of the 2019 general elections.

The three key states going to the polls this year are the Rajasthan, Madhya Pradesh and Karnataka.

Firstly, we will be closely monitoring whether Modi’s party, the BJP, manages to take back the large state of Karnataka from the opposition, the Indian National Congress (May 2018). We will also be watching to see if the BJP retains its stronghold states of Rajasthan and Madhya Pradesh (before January 2019).

Indeed, India is a country with immense economic potential, but supply-side reforms remain key to realising it.

Since coming to power, Modi has initiated a powerful reform path that has led to a reduction in the current account deficit, an increase in foreign direct investment and a rebuilding of international reserves (Chart 5).

He has also implemented his famous ‘GST’ (goods and services tax) reform  which should help to broaden an otherwise excessively low tax base.

In terms of monetary policy, former governor Raghuran Rajan restored the credibility to the central bank by containing inflation, therefore allowing his successor Urjit Patel to maintain an accommodative stance.

Finally, at the end of last year, the government began tackling the country’s weak spot, the banking sector, by announcing a recapitalisation plan worth USD 32 billion. The move is already bearing fruit with a significant rebound in bank lending and money supply growth.

Mexico

The Mexican presidential election (July 1) is probably the most important election in the emerging world this year, especially with NAFTA (North American Free Trade Agreement) being renegotiated.

Indeed, according to the latest polls, the anti-establishment candidate ‘AMLO’ (Andres Manuel Lopez Obrador) has a real chance of winning after his defeats in 2006 and 2012.

Unfortunately, a victory for AMLO would most likely slow the country’s reformist and pro-business approach, and the probability of NAFTA ending badly might increase somewhat.

Economically, Mexico has suffered since Donald Trump was elected US president, with the drop in the peso leading to strong inflationary pressures and forcing the central bank into tightening mode (Chart 6).

That said, growth has remained resilient (Chart 6) thanks to solid structural fundamentals, with a low current account deficit, a growing labour force that has become more competitive than China, and a string of structural reforms in recent years.

In this context, the outcome is binary.

If AMLO is not elected and NAFTA’s agreement is not too disruptive, the economic situation would improve. On the other hand, a victory for AMLO and/or an abrupt end to NAFTA would most likely lead to further difficulties for the country.

Brazil

Last but not least, the presidential elections in Brazil (October 7 & 28), which may be the second most important election this year after Mexico.

Indeed, despite strong cyclical momentum, the country suffers from a largely loss-making pension system resulting in one of the worst public deficits in the emerging world (Chart 7).

Unfortunately, Brazil lacks a strong leader with the ability to pass unpopular but necessary structural reforms – as Mauricio Macri has done in Argentina.

Indeed, former President Dilma Rousseff was impeached amidst the Petrobras scandal. Her successor, Michel Temer, who has also been implicated in corruption scandals, is extremely unpopular. And the only candidate who has made it to the front pages yet is ex-president Luiz Inacio Lula da Silva, who is currently sentenced to jail for corruption and not allowed to run for now.

As a result, the presidential race remains wide open and this election could mark a turning point in policy direction, depending on the next president’s ability to deeply reform the pension system.

Economically, the dynamic is strong thanks to a supportive global environment that allowed for a rapid rate-cutting cycle. However, despite a clear improvement in the current account deficit, the budget deficit is far too large (Chart 7), due to a loss-making pension system, with spending surging while revenues decrease. As long as this issue remains unresolved, the country will not be able to maintain single-digit interest rates and low inflation in a sustainable manner.

To sum-up, seven main elections will  take place in the largest emerging countries this year, of which two are potential game-changers – the Mexican and Brazilian presidential elections – one should not be underestimated – the Indian state elections – and the other four should not change the current dynamic in their respective economies – Colombian legislative & presidential elections, Russian presidential elections, Hungarian and Malaysian legislative elections.