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New research disproves a pearl of conventional wisdom – that a move to a democratic form of government is good for investors in that country.
Indeed, much of the conventional wisdom about investing is wrong. Another example is that investors seeking high returns should invest in countries that are forecasted to have high rates of economic growth, such as India and China.
It is intuitively logical that if you could accurately forecast which countries will have high rates of economic growth, you could exploit that knowledge and earn abnormal returns. Unfortunately, relying on intuition often leads to incorrect conclusions.
In this case, the wrong conclusion is reached because it fails to account for the fact that markets are highly efficient in building information about future prospects into current prices. The historical evidence on the correlation of country economic growth rates and stock returns demonstrates this point. Researchers, including Jay Ritter (Economic Growth and Equity Returns), Jeremy Siegel (Stocks for the Long Run) and Antti Illmanen (Expected Returns) have found that there has actually been a slightly negative correlation between country growth rates and stock returns.
Democratization
The conventional wisdom on democratization (based on consumption theory) is that it leads to a lowering of the ex-ante equity risk premium. That view is based on the belief that democracy increases the economic surplus of a country, and the economic pie gets larger for everyone.
Is that actually the case?
Despite the importance of the question, the literature is blank on the subject.
Max Miller, author of the January 2020 paper “Democratization, Inequality, and Risk Premia,” sought to answer the question. Miller begins by noting: “Since the industrial revolution, the world has seen three waves of democratization. These democratizations, broadly defined as extensions of political rights to groups of people previously excluded from political processes, were fraught with inter-socioeconomic class tension, causing uncertainty for the politically powerful and economically wealthy. The finance literature has mostly focused on political uncertainty within a given political system, or risk brought about by changes to the so-called ‘rules of the game.’ However, uncertainty over ‘the game’ itself has been largely ignored. Democratizations are steeped in political uncertainty and act as an ideal laboratory to study its effects. By studying asset markets, I observe how the preferences and expectations of the wealthiest members of these societies reacted to democratizations.” His sample covered 57 countries spanning 200 years.
Findings
Contrary to what conventional wisdom, Miller found that both the equity risk premium (based on the dividend yield and the five-year cyclically adjusted price-to-earnings, or CAPE, ratio) and corporate credit spreads become highly elevated at the beginning of periods of democratization, indicating they are periods of increased risk for investors. The increase in ex-ante premia are large and economically meaningful, roughly the magnitude of the increases in risk premia observed during financial crises – the average excess equity returns five years ahead are elevated by 4 percentage points during the first five years of the democratization start, and the credit premium widens by 2.4 percentage points. Miller concluded that these results imply that perceived risk within financial markets are high during periods of democratization.
In contrast to rising risk premiums, Miller found that periods of democratization have little to no effect on macroeconomic aggregates, such as consumption growth, consumption volatility or dividend growth – “dividends, default probabilities, and consumption are not largely affected by periods of democratization,” presenting a challenge for consumption-based asset pricing theories.
Miller explains the contrasting findings by noting: “Equity owning elites with de jure political power try to avoid redistributing their income and wealth to poor, hand-to-mouth citizens with de facto political power in that they outnumber the elites and can revolt. The primary friction is the commitment problem faced by the elites; they are not able to commit to future payoffs when there is no revolutionary threat. Democracy acts as a way for the elites to commit to future redistribution and prevent a contemporaneous revolution. But, redistribution comes at a significant cost, making it a highly undesirable state for the elites. Uncertainty around whether redistribution will occur causes premia to spike.” He added: “The wealthy are the ones who price assets, leading the resulting uncertainty over future cash flows to cause discount rates and credit spreads to rise and, therefore, asset prices to fall. In this way, democratizations that are accompanied by a redistribution of wealth, income, and political power act as rare and disastrous outcomes for the politically elite.”
Miller explains that while democratizations are positive events for the vast majority of people in the societies in which they occur, the minority that are most negatively affected control much of the economic and financial wealth and political power. In these episodes, this powerful minority may lose not only their economic wealth but also the political advantages used to generate it. In this case, democracy serves as potentially disastrous outcomes for political elites. And since the elite control the wealth, that uncertainty causes the equity and credit risk premiums to rise. He explains: “During periods of inter-socioeconomic class conflict, risk premia will not be egalitarian measures of macroeconomic distress. Rather, they will unveil the preferences of the few opposed to those of the many. This is particularly true in developing and autocratic societies where economic and political inequalities are far greater.”
Another interesting finding by Miller was that corporate credit spreads fall during periods of democratization, beginning in 1984. He offered the following explanation for this regime change. “Markets have become more globalized over time, allowing the wealthy in autocratic countries to diversify much of their country specific risk. When such risk is perfectly diversified, investors would no longer price it meaning that only the positive macroeconomic effects of democratization would be priced.”
His findings led Miller to conclude: “There are frictions that prevent democracy from consolidating, namely that those who are adversely impacted by its manifestation are exactly those with political power and economic wealth. This means that democracy will not consolidate unless these agents are sufficiently motivated.”
Summary
Miller’s findings demonstrate that financial markets view democratization adversely because of the uncertainty it creates for the elites who control the wealth. However, this does not mean it is bad for the macroeconomy. His major contribution is that not only political uncertainty but also inter-socioeconomic conflicts stemming from wealth and income inequality have major roles in asset pricing. Keep Miller’s findings in mind whenever you read the economic forecasts of gurus predicting market outcomes based on democratization.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
