Beware the market’s tendency to kill its darlings; Investors are by nature fickle and easily disappointed, writes Ruchir Sharma

April 13, 2014 6:03 pm

Beware the market’s tendency to kill its darlings

By Ruchir Sharma

Investors are by nature fickle and easily disappointed, writes Ruchir Sharma

The myth of the “fragile five” has shattered. Just a few months ago investors were abuzz about the risks posed to Brazil, India, Indonesia, Turkey and South Africa by rising current account deficits and growing dependence on fickle foreign capital flows. Now two of these supposedly brittle economies – Indonesia and India – rank among the emerging world’s best-performing equities markets so far this year.

The big change is in politics, as new leaders promise to repair the cracks in the economy. Polls project victory for Joko “Jokowi” Widodo in Indonesia’s July presidential elections, despite the recent setback his party suffered in legislative polls, and the stock market seems to approve: it is up 20 per cent in dollar terms. India, though a long way short of its all-time highs in dollar terms, is up 10 per cent on the growing likelihood Narendra Modi will win the ballot that began last week. Both men are seen as energetic replacements for weak incumbents, and analysts are crediting the personalities behind the “Jokowi rally” and the “Modi rally”. In Brazil, President Dilma Rousseff is still the frontrunner, but the market jumps whenever newspaper headlines hint that she could lose. This is an “anyone but Dilma” rally.

It is hard to remember a time when markets were responding so directly to fresh political personalities. In the two years before the global financial crisis of 2008, voters in 30 of the world’s largest democracies rejected the incumbent in only one out of every three elections. In the last two years, that rejection rate had risen to two out of three, and markets are embracing the newcomers. Earlier personality-driven rallies accompanied the 2010 victory of Benigno Aquino III in the Philippines, and the 2012 triumphs of Enrique Peña Nieto in Mexico, and Shinzo Abe in Japan.

This year, politically driven rallies are breaking out with even more force, in part because this is a big year for elections – with 40 per cent of the 110 emerging democracies holding national polls. Six major emerging markets will hold votes in the next six months – a concentration of big elections not seen since the halcyon days of 2006, when investors were rooting for continuity rather than change.

Now frustration is bubbling over. Over the past decade the average age of political regimes in the big emerging markets doubled from four years to more than eight, and it is no accident that most of the fragile five had administrations that were more than eight years old. The growing complacency of these stale regimes set the stage for the rising current account deficits and other financial missteps that produced runs on these currencies last year.

Today markets are recovering in countries where prospects of a leadership change are growing. Six months ago Mr Modi was not yet a clear frontrunner, Ms Rousseff was a shoo-in and Mr Widodo was not even a declared candidate. Opinion polls can often be unreliable, but it is hard to ignore the trend in favour of the challenger in all three of these countries. In South Africa and Turkey, which also hold national elections this year, there is no strong challenger, and markets are barely registering the coming polls.

There is the ‘Jokowi rally’ in Indonesia, the ‘Modi rally’ in India – and the ‘anyone but Dilma’ rally in Brazil

Looking back 20 years at the market reaction to 140 national elections in the 30 major democracies, it is clear that markets often rise during the campaign of a reform-minded challenger, and they take off if that challenger comes to power in the wake of a financial or political crisis and then delivers on reform. There were 16 such post-crisis cases. One was the rise of Kim Dae-jung in South Korea following the Asian financial crisis of 1997-98. Another was the election of Luiz Inácio Lula da Silva, just as the spectre of sovereign default threatened Brazil in 2002. In such circumstances, on average, the local stock market beats the emerging market average by about 40 percentage points in the first 18 months of the new regime.

Still, market darlings cannot rest easy. Investors tend to project their hopes for change on to promising candidates. They are easily disappointed. Enthusiasm for Mr Abe and Mr Peña Nieto has waned of late as questions arise about the impact of their reforms. Even if challengers win, they need to deliver on the expectations of change, or there is no hope for their rallies.

The writer is head of emerging markets and global macro at Morgan Stanley Investment Management