• Half of Emerging-Market Bond Index Faces Election Risk in 2018

Investors set to bag the best returns in five years from emerging-market bonds this year should brace themselves for 2018. Political risk looms large.

Countries that make up more than 50 percent of a Bloomberg Barclays developing-nation local bond index are gearing up for elections in the next 12 months.

While the outcomes of votes in countries like Russia are predictable, tight contests in heavyweights like Brazil and Mexico have potential to cause bouts of volatility. That may catch some investors off-guard after they piled into emerging-market assets this year in search of higher returns as yields in developed markets grind ever lower.

“Investors are definitely beginning to think about this stuff, but I suspect they aren’t prepared,” said Kieran Curtis, a money manager at Aberdeen Standard Investments in London. “Brazil’s election isn’t until the end of the year, but it’s still somewhere that asset managers are holding quite a lot of risk.”

If history is anything to go by, traders need to start getting their act together. A report published by Citigroup Inc. earlier this month that detailed the election risks over the next 18 months in 20 countries concluded that elections have played a crucial role in the timing of “things going wrong” in emerging markets.

Analysts at the bank highlight financial crises in Mexico in the ’70s, ’80s and ’90s, which all coincided with elections, and midterm votes in Argentina in 2001, which helped pave the way for the country’s default a few months later. Uncertainty over Brazil’s 2002 election caused spreads on the nation’s debt to surge as high as 2,450 basis points, they said.

“It is certainly not the case that there is an ‘election curse’ or that every election is bound to create volatility,” said the analysts including David Lubin. “But there has, historically at least, been some loose connection between elections and crisis.”

Lubin and co. single out elections for South Africa’s ruling party, and general elections in Brazil and Mexico, as having the biggest potential to move markets because all three face tight and unpredictable contests. They recommend investors hedge against currency volatility by taking an overweight position on the dollar three to four months before the elections.

Fiscal deterioration from pre-election policy loosening is possible in South Africa, Indonesia, Pakistan and Costa Rica, they said. A deterioration of debt-to-GDP ratios in “a fairly large number of countries that are going to the polls” might make the market less tolerant about pre-election fiscal loosening than might otherwise be the case, according to the Citi report.

More to Come

The first round of Chile’s presidential elections on Sunday gave investors a warning signal for the possible volatility to come. The peso plunged more than any other currency in emerging markets on Monday after market favorite Sebastian Pinera took a smaller-than-expected lead, putting victory in the final round next month at risk.

Colombia’s presidential election could be “interesting” if it changes the outlook for the country’s sluggish growth, according to Aberdeen Standard’s Curtis. Predictable outcomes in polls in Russia, where Vladimir Putin is expected to run without much opposition, and Malaysia, where the current prime minister is the favorite to win, are unlikely to have much market impact, he said.

Curtis’s preferred strategy for dealing with election risk is to buy bigger stakes in “hideout” countries that have recently passed unscathed through an election cycle. His top pick is Argentina, where market-friendly President Mauricio Macri’s allies cruised to victory in October’s congressional elections. Russia could also be a good option once its vote is over in March, he said.

“It will be a big plus for Argentina to have all of its political issues settled next year, especially since they have a big debt-issuance program,” Curtis said. “Investors will probably start to take pre-election positions as we enter the new year.”