A Fat Tail World – Part 2

By Ian Bremmer

Political risk is the impact of political factors on market performance.

For a company operating overseas, a portfolio manager, a private investor, or anyone else looking to understand how markets perform, a solid grasp of a particular country’s economic fundamentals is crucial. But it’s not enough. Beyond its balance of payments, its inflation and unemployment rates, its bond ratings and growth projections, anyone exposed to market risk in that country must also understand how internal and external political factors will impact its markets.

Looking at the big picture, there are four structural reasons why political factors will increasingly drive global market outcomes over the next several years.

First, the energy that fuels economic growth now comes increasingly from unstable (and potentially unstable) parts of the world-places like the Persian Gulf, the Caspian Sea basin, and West Africa, regions where political risk and security threats often weigh on supply. Oil now sells at about $48 per barrel. If the global economy deteriorates sharply enough over the next few months, the price could drop much lower. But that’s not a sustainable trend. Over time, as global growth returns, prices are likely to move cyclically higher until there’s new, scalable energy technology (and the infrastructure to deliver it) that reduces reliance for supply on these unstable political environments. That’s not a development that’s right around the corner.

Second, emerging markets like China, India, Russia, Brazil, and others have become much more important for the longer-term trajectory of global growth. These countries are less politically stable than developed states, and their economies are driven by relatively opaque political decision-making processes. A global economy that depends for growth on developments in Washington, Tokyo, London, and Berlin is one thing. Growth that depends on political decisions made in Beijing, Moscow, Delhi, Brasilia, Ankara, Mexico City, and other emerging market capitals is quite another.

Third, the broadening availability of dangerous technologies enhances the ability of states and organizations intent on challenging the international status quo to project power internationally — whether through ballistic missile technology, nuclear proliferation, terrorism, insurgency, or even piracy.

Fourth, the growing unwillingness and inability of the United States to provide global leadership over time will make it much more difficult to coordinate responses to these and other transnational challenges. The US lacks the political appetite and the resources to play the role some might have envisioned for it 10 years ago-and to accept the burdens that come with unrivaled long-term leadership. We can’t expect current international institutions to take up much of the slack. Multilateral bodies like the UN Security Council, World Trade Organization, G8, NATO, and the current non-proliferation regime no longer reflect the true balance of global political and economic power in the world, depriving them of the legitimacy they need to play a more stabilizing international role.

These trends have developed gradually over the past two decades. But-and here’s the critical point for The Fat Tail-all four are dramatically magnified in the near term by the ongoing financial crisis.

The global recession has contributed to a drop in energy prices over the past several months as deteriorating local economic conditions reduce demand for oil and gas. But over the longer term, it will add significant upward pressure on prices, because governments are too busy right now bailing out vulnerable financial institutions and economic sectors to devote time, energy, money and other resources to develop hydrocarbon alternatives and climate change reduction measures. The crisis will also diminish the impact of the comparative independence of emerging market decision-making on global market trends, which will increase the desire of these governments to insulate their fortunes from those of developed states over the long run — undermining the dollar as global reserve currency.

The global slowdown will also increase the importance of rogue states and organizations. As domestic economies slow and people lose their jobs, there will be a significantly higher risk of social instability-and greater tolerance of (and, in many cases, outright support for) radical movements and ideologies. This increases the impact of these organizations on the performance of markets-both directly, through the growing potential impact of open conflict, and indirectly, as governments of both developed and developing states divert resources toward countering the growing threat. Historically, civil unrest lags behind the first evidence of a slowdown by several months to a year.

Finally, as the global financial crisis forces governments around the world to respond to deteriorating domestic economic crises, it creates the risk of tit-for-tat protectionism as one government’s subsidy encourages another to raise trade barriers. The need for governments to focus on domestic damage control also makes it more difficult to coordinate responses to the kinds of problems that cross borders — terrorism, nuclear proliferation, organized crime, climate change, public health crises, and the global recession itself.

In short, we can expect more of the fat tail risks outlined in the book. In the next installment, I’ll detail where these risks are likely to generate international hotspots.

For a closer look at The Fat Tail: The Power of Political Knowledge for Strategic Investing, here’s a link: www.fattailbook.com