Key points
- Strong synchronized global growth has led to a drop in intercountry correlations and made risks in individual countries more important than ever for investors.
- We survey key risks around the globe, including trade policy, elections, geopolitical tensions and reform efforts.
- Our preferred countries include Japan, Brazil, India, Indonesia, and China.
Introduction
The benign global economic backdrop has elevated the importance of country risks for investors, driving down intercountry correlations (see Figure 1) and increasing potential opportunities. Country differentiation will matter in 2018, as each country faces a unique set of risks. Naturally, investing in only some of these countries may be worth the risks. Against that backdrop, we survey what we believe are dominant country risks to monitor in 2018, broken down by regions.
Figure 1: Intercountry correlations at decade lows
Americas: It’s all political
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NAFTA. Trade is a key geopolitical risk for 2018, particularly with respect to the NAFTA negotiations. Canadian assets have weathered the uncertainty better than Mexican assets, although local Mexican equities have fared better than expected. The peso has weakened considerably and led to faster inflation and forced tighter monetary policy. With two key elections ahead -- the July 1st Mexican presidential election and U.S. midterms in November -- negotiations may intensify in coming weeks, particularly the March round of negotiations, as the negotiating parties increasingly play to domestic audiences.
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Brazil. The key for Brazil is whether they can pass pension reform. The Temer administration has already passed a number of reforms, including a 20-year constitutional spending cap tied to inflation, which has lifted the economy out of a deep recession and regained investor confidence. The October presidential elections add another source of uncertainty, which could complicate the necessary fiscal reforms. With economic and earnings growth accelerating and critical catalysts on the horizon, Brazil warrants close attention this year.
EMEA: Localized risks (For now)
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United Kingdom. Brexit negotiations will continue in 2018 after making sufficient progress in the first round of negotiations which concluded in December, 2017. The next phase will cover the transitional phase to avoid a hard exit in March 2019; the March 2018 summit will be the next milestone in negotiations to watch for.
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Italy. The elections on March 4th is one of the eurozone’s most notable risks this year. Anti-EU sentiment runs high in Italy, and the center-right coalition has put forward a policy platform which demands fewer constraints from the EU and support for domestically made goods. The right-led coalition also included the small and newly created centrist party, Noi per I’Italia, which may help the coalition’s chances of winning.
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South Africa. The new leadership of the African National Congress (ANC) may increase reform momentum, shifting politics from a headwind to tailwind. ANC President Cyril Ramaphosa outlined his vision for a ‘New Deal for South Africa’, with the goal of raising economic growth, restoring fiscal discipline and central bank independence, and cracking down on corruption, particularly at state-owned enterprises.
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Turkey. Fiscal stimulus has provided a strong cyclical boost to the domestic economy, helping ignite a rally in local equities. However, its external balance remains tenuous, as Turkey’s large current account deficit has weakened the lira while the banking system’s excess reliance on U.S. dollar funding makes it heavily dependent on capital inflows. With the U.S. dollar and U.S. interest rates expected to rise throughout 2018, Turkey’s balance of payments warrants watching, as does its volatile political climate.
Asia Pacific: Solid fundamentals belie trade risks
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Japan. Abenomics will continue following Shinzo Abe’s resounding reelection as Prime Minister last October. However, questions around the Bank of Japan’s (BoJ) monetary policy may come into sharper focus. The BoJ announced a tapering of long-dated bond purchases on January 9, 2018, raising speculation it may adjust its yield curve control target. Despite these concerns, the BoJ has repeatedly stated – and demonstrated – its resolve to reach 2% inflation.
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China. Following the 19th Party Congress in October 2017, China will embark on an ambitious reform agenda focusing on the ‘quality’ of growth over the quantity, including environmental protections, continued cuts to excess capacity, and curbing excessive credit growth. With President Xi having consolidated power, the U.S. adopting a more isolationist and nationalist position, a more assertive China in the South China Sea, and tensions over North Korea, risks to U.S.-China relations are high.
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South Korea. Growth should remain supported by the global trade and capex cycle abroad and by rising domestic consumption following its new tax and labor reforms, which include a substantial increase to the minimum wage. Aside from the North Korea threat, global trade is a key risk – China is a major South Korean export market, and their rebalancing will affect South Korean.
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India and Indonesia. Both are domestic growth stories, powered by reform agendas in each country. In India, the bank recapitalization efforts may ease credit conditions and address weak banking system balance sheets, while the goods and services tax impact on economic activity is likely to fade over 2018. In Indonesia, the subsidy cuts have improved government revenues, helping enable a 120% annual increase in social payments to lower income households.
Conclusion
Investing in countries always involves both risks and opportunities, but country differentiation may matter even more in 2018 than usual. The decline in intercountry correlations suggests specific country risks will be increasingly important to asset prices. Investing in broad exposures can help mitigate risk, but some of these risks offer potential rewards and outperformance. Specifically, we favor Japan, as well as Brazil, China, India, and Indonesia within emerging markets.
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