Political Risk, Structured Evolution

Political Risk, Structured Evolution

Political risk analysis, like most other disciplines, evolves. Responding to new stimuli, it moves in different directions, trying to make sense of - or forecast - the events for which it is designed.

Early forms of political risk can be traced to trade relations between the Sumer and Indus civilizations of the third millennium BC. The goal of a consideration was for the most part practical: to secure safe passage of goods and return compensation.

This general mode of analysis presumably held sway for some time; and it has been argued that it wasn’t until the 19th century, when transportation costs eased sufficiently to allow for commodity prices in Europe and Asia to converge that globalization – and the dimension of political risk that concerns itself with cross-border trade and investment – gathered steam.  Larger volumes of trade and investment flows, involving more and more transactions, led naturally to more sophisticated or involved methods of risk analysis.

Consequently, structured political risk analysis is important.  It forces us to think in ways that lead to a forecast that is accurate. Relevant risk metrics are assembled, weighed against qualifying criterion, confidence intervals are constructed, and then injected into a larger analysis. While important, political risk analysis should be more than a collection of opinions.

Given its dual qualities – a discipline that should evolve over time yet be bound by rules or strictures that imposes discipline – I am reminded of one of the great contributions made by America to modern music, namely: jazz, which shares similar qualities.

To be sure, we have different genres of jazz (bebop, West Coast, fusion). But in evolutionary terms – those forms that broke new ground - one can’t help but think of the new terrain that was uncovered in the modal sounds of Miles Davis in the 1959 recordings for Kind of Blue. 

The album showed how jazz improvisation could be based on defined scales and therefore achieve effects that were not possible through the chord-based improvisations of earlier jazz groups.  In some way, Kind of Blue was a rejection of the limits imposed on musicians by tradition.

But jazz also has a structure. There is the melody; then there are the variations, over which the harmonies are improvised; and then there is return to the melody, in which the original theme is addressed again. The themes are usually 32 bars in duration with four beats in each bar (think standard tunes by Gershwin and Cole Porter).

For some time, I have insisted that for political risk to be especially meaningful, it should be quantified, and looked at uniformly over time and between jurisdictions. It should also be - as much as possible - applied to the behavior, pricing and protection of assets.  Last month I added to this requirement, suggesting that - particularly when it involves making forecasts - political and country risk analyses ought to be as accurate as possible.

The stature of PRS as the only quant-driven political risk firm that now interfaces four decades of independently back-tested proprietary risk data with artificial intelligence represents a reaction to what has come before, and indeed to a world that has becoming subjected increasingly to sophisticated algorithms. Over the balance of the year we will be building out this unique position in the market.

Turning to our ratings for the month, Peru’s risk profile deteriorated slightly as President Pedro Pablo Kuczynski was forced to form a new cabinet after Congress pulled its confidence in the old one following a clash over a teachers’ strike and policy on education.  Fortunately, the new executive as won the praise of the opposition, suggesting that subsequent and near-term votes of a similar nature may be on hold for the time being.

However, some from the president’s centrist and leftist support criticized the new appointment as a sop to the Popular Force, the right-leaning party in congress, which has an absolute majority.

In a slightly more dramatic fashion, Iceland’s government collapsed, too, this month over a letter of recommendation written by the prime minister’s father on behalf of a convicted pedophile. This fall of the government represented the third such center-right government in a row to lose the confidence of parliament before serving out a full term. 

A vote is to be held on October 28th, and will likely result in another fragmented parliament.  As such, process of coalition-building will remain difficult, suggesting that a return to the relatively high levels of political stability normally enjoyed by the country might be some away.

Finally, in Japan, Prime Minister Shinzo Abe has announced plans to dissolve the parliament and hold a general election in the second half of October, more than a year before the Liberal Democratic Party (LDP) government is required to seek a renewal of its mandate. 

Corruption scandals implicating the prime minister and his wife sent Abe’s approval rating plummeting, with the results of three polls released in July putting his support at less than 30%.  However, his popularity has rebounded in step with the rising security threat posed by North Korea, which has reordered the priorities of Japanese voters, who are now more concerned about Abe’s leadership abilities than his ethical lapses.  With polls conducted in September showing an average approval rating of 44%, and a recent FNN poll putting his support above 50%, the prime minister is gambling that acting now will enhance his chances of securing a fresh four-year mandate.

The LDP is polling closer to 40%, but support for the main opposition Democratic Party (DP) is stuck in single-digit territory, and no other party is polling higher than 5%.  That said, some 40% of the electorate remains undecided, creating the potential for an unexpected outcome. 

For additional insights on the uncertainty surrounding the election, clients and friends are directed to the new ‘Flash Forecast’ feature of PRS’ critically-acclaimed World Service. (http://epub.prsgroup.com/products/world-service)

Our ratings this month also provides insight into the positions taken in PRS’ asset portfolio. We have put some long positions on various agricultural commodities and are waiting for a recent surge in the greenback to ease in order to initiate additional long positions in various emerging markets.  The Trump administration’s plan to cut tax rates for US firms has induced some concern in the markets, who fear the efforts will lead to the repatriation of dollars. 

PRS thinks the reaction is a little overblown as the tax plan is rather complicated and it’s not entirely clear whether the president will have necessary support from congress to pass the legislation – and indeed in what form. Consequently, while we continue to favor the Mexican peso, our models are also bullish on various Asian currencies, including Indonesia’s rupiah and Malaysia’s ringgit.

PRS continues to receive wonderful coverage in the financial press, and our data series continues to inform the work of various multilateral agencies. 

Using PRS’ risk metrics, Barron’s reported that Accuvest Global Advisors, with $400mn in assets under management, ranks Poland high on its list of country bets, with more ‘room to run.’  The country is second in the firm’s ranking for share-price momentum, thanks to the stock rally this year. Poland is rated 11th out of 34 markets in terms of overall risk, according to ICRG’s composite scores. (https://lnkd.in/ePRNHmT)

Is growth in Africa different? This was the question posed by IMF researchers recently. Using an array of our datasets, the IMF looked at growth performance in Sub-Saharan Africa, and found that what determines growth spells in the region are different from those in other emerging markets. (https://lnkd.in/dBdefr5)

For some time, more and more emerging markets have been issuing local currency debt with longer maturities, giving rise to considerable stability in the asset class. Our risk metrics are used extensively in this study by the IMF, underscoring the importance of understanding the contributing factors for confident long positions. (https://lnkd.in/gpazNkA)

Finally, clients should note that this month’s political risk adjustments affected 55 countries, with some 77 individual risk metrics changed accordingly.