In 2018, politics could matter in emerging markets

All politics may be local, but investors around the world still need to care about them.

There are high-stakes elections on the calendar this year in key emerging markets, stretching from South America to Asia. Regardless of how the results pan out, emerging-market stock and bond funds may swing widely in the interim following their stellar and nearly uniformly upward ride in 2017.

Higher highs and lower lows are nothing new for emergingmarket funds, which invest in stocks and bonds from China, Brazil and other developing countries. These economies are growing at a faster pace than the developed world, which can mean bigger profit possibilities for their companies and higher yields for their bonds. They also tend to have steeper downturns than the U.S. market when trouble strikes.

Last year was an exceptional one for emerging-market stock funds, which returned an average of 34 percent compared with the roughly 22 percent return for S&P 500 index funds.

Investors poured more than $50 billion into emerging-market stock funds during 2017, just two years after they pulled more money out of such funds than they put in, according to Morningstar.

Those investors got a reminder of the potential volatility in recent weeks, when emerging-market stock funds mirrored the steep losses in S&P 500 index funds.

For this year, much attention is on elections coming up in Brazil and Mexico, which are two of the larger components of many emergingmarket funds. Together, they make up about 10 percent of the MSCI Emerging Markets index.

In Mexico, the front-runner in the July election for president is Andres Manuel Lopez Obrador. Some investors worry that a Lopez Obrador victory could lead to a rollback of market-friendly policies or of more acrimonious negotiations for the North American Free Trade Agreement.

Concerns are also high that Brazil’s presidential election could hinder efforts to reform the country’s pension system and make other fiscal changes. Brazil only recently emerged from a punishing recession.

Last year politics didn’t seem to matter to investors. Markets registered only minor hiccups when Catalonia declared independence from Spain and rhetoric got heated between nuclear-armed North Korea and the United States. The year before that, though, politics mattered when the United Kingdom’s vote to leave the European Union shook markets around the world.

Even with the increased possibility of election-related turbulence, many fund managers say they remain optimistic about the prospects for emerging markets. Emerging economies are in better fiscal shape than they were before prior downturns, and their stock and bond markets are typically less expensive than markets in the United States.

Plus, the gap between the developed and emerging worlds may be slimming when it comes to how much of a risk politics can play. In the United States and elsewhere in the developed world, one of the main causes for anger is the growing inequality between the rich and everyone else.

In the emerging world, the opposite is happening, said Samy Muaddi, portfolio manager at T. Rowe Price. Middle classes are expanding in many emerging markets, with wages rising and more people owning property.