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Market euphoria rests on more than stimulus

The market interpretation of the US election result can be expressed in just three letters, repeated several times: “USA! USA! USA!” Amid the noise that followed last week’s election victory for Donald Trump, one signal was clear — whatever the outcome will be the US, it will be far worse for the rest of the world in general, and emerging markets in particular.

Outside of financial crises, the violence of the move towards the US and out of everyone else was unprecedented. The performance of the US S&P 500 index has beaten that of the MSCI EAFE index, the most popular benchmark of the developed world outside the US, to the greatest extent since the index was created some four decades ago. Its outperformance of MSCI’s emerging markets index, which had been staging an impressive rebound for much of this year, has been more than 10 percentage points in barely a week.

Such scepticism towards emerging markets of course makes sense, as I noted last week. Mr Trump’s promises of protectionism might well damage the US but they would certainly damage emerging markets, which tend to be particularly reliant on exports. His focus on China, to which much of the fate of the rest of the emerging world is tied, threatens extreme disruption if it comes to pass. And higher US bond yields and a stronger dollar attract funds to emerging markets. Even if Trumponomics prove bad for the US (which is quite possible), they would be far worse for emerging markets.

But we should all step back and look a little deeper about what is implied. The last great emerging markets bull market, from 2002 to 2008, was predicated on the notion of “decoupling” — that the emerging world could continue to thrive even if the developed world fell into recession. The EM crash during the financial crisis disproved the notion. Now, we have moved to the idea that the US can prosper as the emerging world languishes.

This is also a questionable, for a reason that goes beyond economics to the deeper cause for the gap between the developing and emerging markets: their institutions. It is a weak institutional structure that keeps a country in emerging status. If democracy or the law is weak, if there is not a backbone of trust or an agreed route to combat corruption, development and growth are far harder.

Lacking full shareholder protections, EM companies are likely to be controlled by families or founding institutions, or by the state. Companies with the widely dispersed ownership in the US are unusual.

In the emerging world, these things matter. Research by London’s Ecstrat shows that control has a huge impact on valuation and performance. Family-owned EM companies, despite their governance issues, have outperformed world stocks over time — state-controlled enterprises seriously lag it.

Where institutions are fragile there is a risk that they will be replaced either by a more authoritarian government — as may be happening, in different way, in countries as diverse as China, Russia, Turkey, Poland and Malaysia — or by a vacuum. Neither is good either for investment returns or, more importantly, for the creation of wealth and prosperity. Again, this drives returns. Countries with inadequate bankruptcy protections, or a risk of government confiscation, tend to underperform.

But developed world institutions are also fragile. If governments fail to deliver growing prosperity or — more importantly — even a sense of fairness, the critical institutions can weaken swiftly. That is the greatest risk at present.

I recently re-read Fault Lines, a superb book on the causes of the financial crisis written by the economist Raghuram Rajan between his stints as chief economist of the International Monetary Fund and head of India’s central bank. It now reads quite prophetically. Early on in his text, Mr Rajan made a warning. “Deep imbalances such as inequality can create the political groundswell that can overcome any constraining institutions,” he wrote. “Countries can return to developing-country status if their politics become imbalanced, no matter how developed their institutions.”

How great is such a risk? Evidently the “elites” in Britain and the US are viewed as discredited and untrustworthy by a huge chunk of their populations. Nothing else can explain this year’s election results. Beyond politicians, that includes banking systems — very much including central banks — and the conventional media, now generally referred to as the “Mainstream Media” (MSM).

In the UK, the extraordinary attacks on the judiciary following the ruling that the Brexit process must be preceded by parliamentary debate suggests that the justice system is also now in disrepute. In the US, the supreme court becomes ever more politicised. Trust in police forces and in government surveillance is low and falling; even the FBI appears compromised by the election campaign.

All of this matters. To anyone used to covering emerging markets, goings on such as the dip in the pound when the new prime minister criticised the Bank of England’s governor, Mark Carney, and the rebound when he announced he was staying, sound painfully familiar. Ditto the fall in Amazon’s share price amid speculation that the incoming president will exact retribution for the coverage of him by the Washington Post, which is owned by Amazon’s Jeff Bezos. Such things do not happen in a healthy and functioning democracy.

The wave of rejections of western elites may not be over. Next year brings the possibility of the worst blow, with the candidacy of Marine Le Pen for the French presidency.

A victory for her might well mean Frexit — a French departure from the eurozone and the EU and with it the collapse of both in any recognisable form. Markets are right to move on the assumption that the US could prosper more than anyone else in this ugly new world. But the weakening of trust and institutions could yet bring even the US back to emerging status.

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