Will Egypt Tensions Push Investors Out of Emerging Markets?

I've been transfixed following the events in Egypt over the past few days, trying to think through the implications of what's occurring. A country with an economy the size of Ireland or Israel, with a populace the size of Germany, went from "stable" to effectively lawless in under 100 hours. It's also been a case study in the fractured and rapidly-changing media world of 2011. It's been a coming out party for the value and power of social networks, but also for Al Jazeera English, whose internet live feed and coverage of this story reminds me of the importance of CNN's coverage of the 1991 Gulf War. It's badly caught off guard both the American media, which took until Friday to grasp the importance of the events, and the Obama Administration, which has appeared woefully behind the curve in reacting to the rapidly-changing situation. Hillary Clinton's quote on Tuesday of, "Our assessment is that the Egyptian government is stable," may be the Obama Administration's "Brownie, you're doing a heckuva job" moment.

I wrote in my year-end piece about 2011 being a year of disputes, and while I was thinking more along the lines of economic and controlled political disputes, it's no surprise that it has already led to even more volatile events. (See Resolution and Recovery: Disputes to Watch in 2011.) While the year is still young, it's hard not to see parallels to 1989:
 

• The Soviet Union pulled out of Afghanistan in February
• Tiananmen Square protests in China occurred between April and June
• Two million people in Estonia, Latvia, and Lithuania demanded independence from the Soviet Union in August
• The October mini-crash in the stock market, kicked off thanks to a botched LBO of UAL Corp (UAL), parent company of United Airlines
• The Berlin Wall fell in November
• The Velvet Revolution in Prague occurred in November
• First free elections were held in Brazil and Chile in November and December

What does this mean for asset markets? As I mentioned in Thursday's piece, Quantitative Uneasing: How Fed Policy Ties Into Revolts in Tunisia and Egypt, the risk stemming from policy problems is high. That could be a hiccup in the credit markets from squabbling in the PIIGS countries or debt ceiling/QE pushback in the US, or from overzealous policy tightening by central banks in the emerging markets. And now, with Egypt on the brink, the risk of a domino effect in North Africa and the Middle East leading to an oil supply shock has gone up considerably. This is awful news for countries heavily reliant on energy imports, particularly China and India, who are already grappling with inflation problems.


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Emerging market equities, despite strong long-term fundamentals, appear to have many near-term headwinds. Better-than-expected global growth will force their central banks to tighten more aggressively. Worse-than-expected US growth could lead to even more quantitative easing, leading to even more severe inflationary pressures in the emerging market world. Riots and revolutions in the Middle East and elsewhere could make big global asset allocators shift assets from the unstable EM world back into the relative tranquility of the US and Japan. This fits into the view that going forward the correlations of 2007-2009 will continue to abate. And indeed, it's already happening. Year-to-date, the Dow Industrials are up 2.1%, the Nikkei is up 1.3%, while the iShares MSCI Emerging Markets Index (EEM) is down 4.8%.

I remain of the view that risk from the economy in 2011 is low, while the risk from geopolitical and monetary policy errors is extremely high. If Egypt can fall in four days, investors must remain especially vigilant, and think about getting even more of their news from emerging sources like blogs and twitter.