A man walks past a display showing bank notes Anthony Wallace/AFP/Getty Images

The Real Risk to the Global Economy

One might assume that the brewing crises on the Korean Peninsula and in the Middle East pose a serious threat to the current global economic expansion. But political crises often induce only brief market corrections, whereas gradual shifts in international global institutions can be far more consequential for investor behavior.

WASHINGTON, DC – 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 World’s Opinion Page

Help support Project Syndicate’s mission

subscribe now

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.

http://prosyn.org/DFr7oEE;

Handpicked to read next

  1. Television sets showing a news report on Xi Jinping's speech Anthony Wallace/Getty Images

    Empowering China’s New Miracle Workers

    China’s success in the next five years will depend largely on how well the government manages the tensions underlying its complex agenda. In particular, China’s leaders will need to balance a muscular Communist Party, setting standards and protecting the public interest, with an empowered market, driving the economy into the future.

  2. United States Supreme Court Hisham Ibrahim/Getty Images

    The Sovereignty that Really Matters

    The preference of some countries to isolate themselves within their borders is anachronistic and self-defeating, but it would be a serious mistake for others, fearing contagion, to respond by imposing strict isolation. Even in states that have succumbed to reductionist discourses, much of the population has not.

  3.  The price of Euro and US dollars Daniel Leal Olivas/Getty Images

    Resurrecting Creditor Adjustment

    When the Bretton Woods Agreement was hashed out in 1944, it was agreed that countries with current-account deficits should be able to limit temporarily purchases of goods from countries running surpluses. In the ensuing 73 years, the so-called "scarce-currency clause" has been largely forgotten; but it may be time to bring it back.

  4. Leaders of the Russian Revolution in Red Square Keystone France/Getty Images

    Trump’s Republican Collaborators

    Republican leaders have a choice: they can either continue to collaborate with President Donald Trump, thereby courting disaster, or they can renounce him, finally putting their country’s democracy ahead of loyalty to their party tribe. They are hardly the first politicians to face such a decision.

  5. Angela Merkel, Theresa May and Emmanuel Macron John Thys/Getty Images

    How Money Could Unblock the Brexit Talks

    With talks on the UK's withdrawal from the EU stalled, negotiators should shift to the temporary “transition” Prime Minister Theresa May officially requested last month. Above all, the negotiators should focus immediately on the British budget contributions that will be required to make an orderly transition possible.

  6. Ksenia Sobchak Mladlen Antonov/Getty Images

    Is Vladimir Putin Losing His Grip?

    In recent decades, as President Vladimir Putin has entrenched his authority, Russia has seemed to be moving backward socially and economically. But while the Kremlin knows that it must reverse this trajectory, genuine reform would be incompatible with the kleptocratic character of Putin’s regime.

  7. Right-wing parties hold conference Thomas Lohnes/Getty Images

    Rage Against the Elites

    • With the advantage of hindsight, four recent books bring to bear diverse perspectives on the West’s current populist moment. 
    • Taken together, they help us to understand what that moment is and how it arrived, while reminding us that history is contingent, not inevitable


    Global Bookmark

    Distinguished thinkers review the world’s most important new books on politics, economics, and international affairs.

  8. Treasury Secretary Steven Mnuchin Bill Clark/Getty Images

    Don’t Bank on Bankruptcy for Banks

    As a part of their efforts to roll back the 2010 Dodd-Frank Act, congressional Republicans have approved a measure that would have courts, rather than regulators, oversee megabank bankruptcies. It is now up to the Trump administration to decide if it wants to set the stage for a repeat of the Lehman Brothers collapse in 2008.