The normal rhythm of politics repeatedly leads the economy of most countries in a circle. The cycle begins with a crisis that forces leaders to adopt reforms that spur economic recovery. Then the leaders calm down, and the economy slides back into crisis. The pattern is repeated all the time, and only a few countries decide to transform in good times, while others rest on their laurels for years. It is easy to understand why, out of the world's nearly 200 economies, only 35 have achieved developed status and remain so, while the rest are still developing, many forever.

However, since 2003, the cycle seems to have broken. The global economy has entered a unique period of prosperity, driven by lower interest rates, increased trade, and higher commodity prices. Global tailwinds were so strong that national leaders did not have to undertake reforms to boost economic growth; the fruits literally fell from the trees into their hands. At the peak of this boom in 2007, almost 60% of the world's economies achieved annual growth of at least 5%. A record number of countries have significantly exceeded the 35% post - World War II average. Even more surprisingly, in 2007, only five economies showed a decline. Everyone seemed to be thriving, with global investors indiscriminately investing hundreds of billions of dollars at a time-

Ruchir Sharma is Head of Emerging Markets and Global Macroeconomics in the Investment Management Department at Morgan Stanley and the author of " Countries Taking the Leap: Chasing the Next Economic Miracle." Published in Foreign Affairs Magazine, No. 5, 2014. © Council on Foreign Relations, Inc.

growing stock markets, not caring about the differences between, say, India and Indonesia.

In 2008, the financial crisis hit, and the tailwinds subsided. By 2014, the share of global economies growing at 5% or higher had fallen from 60% to 30%. The threat of crisis and recession loomed like a dark cloud, forcing investors to become very choosy - in a completely new way. Market players usually take into account data on the economic outlook - GDP growth, employment, trade, etc. - and respond to them. But recently, investors have been looking in a different direction - at the political leadership. Stock markets from Japan to Mexico are booming in the hope of political change, especially when new leaders appear capable of economic reform.

Political leadership is becoming increasingly important to the economy's prospects, and the associated spikes in stock market hopes are becoming more frequent, especially in this election-rich year. Of the 10 emerging democracies in 44 countries, including the six largest, a national vote has already taken place or is about to take place in 2014. Elections did not affect markets everywhere: where there was little hope of a change, as in South Africa or Turkey, the markets mostly ignored the campaigns. But in countries where promising newcomers have gained popularity, markets have been keeping a close eye on the election. In Indonesia, the so-called Jokowi boom began in December last year, when polls began predicting the upcoming presidency of Joko "Jokowi" Widodo, and continued after his victory in July. A similar pattern - the "Modi boom" - has been observed in India since Narendra Modi became the opposition's candidate for prime minister last September, and continues after his victory in May.

Before, investors never so often called the ups and downs of market conditions by the names of people, as meteorologists do with hurricanes. This happens even in the developed world of more mature economies, where policies usually do not have a significant impact on growth prospects. When reformist Matteo Renzi became Italy's prime minister in February, there was talk of a " Renzi boom."

At the same time, in Latin America, investors are so desperate to see new faces in politics that market surges are already taking place against the backdrop of bad news for current leaders. Argentine markets began to rise at the end of last year after reports of the deteriorating health of populist President Cristina Fer-

Nandez de Kirchner. And in Brazil, where the ruling Workers ' Party is blamed for stagflation, the stock market is buoyant every time President Dilma Rousseff's approval rating drops ahead of the October election. In Sao Paulo, investors call this "anyone but Dilma" support.

Why is politics suddenly having such a serious impact on financial markets? The answer lies in the structure of the economic growth model, which relies heavily on high commodity prices, low interest rates, and other global profit drivers of the past decade. In good times, many leaders ignored the need to continue with reforms and invest income wisely. As a result, their countries struggle to maintain growth. For example, in the three largest commodity-exporting countries - Brazil, Russia and South Africa - GDP growth has fallen to 1% or less this year, while inflation has risen to almost 6%. This has led investors to watch closely for signs of emerging leaders with new ideas.

Another reason for the increased importance of politics for markets is that the two conditions necessary for an orderly change of leadership and a rapid recovery of the economy - free elections and free markets - have become ubiquitous in recent decades. Since the financial crises of the 1970s weakened autocratic regimes,the number of States with free elections has tripled, from about 40 to 120. However, it was only after the fall of the Berlin Wall that many major developing countries took the next necessary step, opening up their stock markets to foreign capital. But even after that, they did not appear on the radar screens of global investors for another 10 years, as the development of economies was hindered by the currency crises of the 1990s. Therefore, until recently, it was simply impossible to count on their rise.

MARKET LEADERS

Market surges have occurred on global markets before, but on a much smaller scale. An analysis of how stock markets have responded to 140 national election campaigns in 30 major democracies over the past 20 years shows that investors are particularly sensitive to the conditions close to today, when reform-oriented candidates come to power against the backdrop of financial crises.-

a political crisis and actually start acting. Over the past 20 years, 16 leaders have met this description. On average, in their first year and a half in office, stock market activity in these countries outperformed the emerging market average by a record 40 percentage points.

The four leaders in this group, who came to power after the currency crises of the late 1990s, deserve special attention because they represent the most important generation of recent economic reformers in the developing world. They are Kim Dae-jung, President of South Korea from 1998 to 2003; Vladimir Putin, Russian leader since 2000; Luiz Inacio Lula da Silva (Lula), President of Brazil from 2003 to 2011; and Recep Tayyip Erdogan, Prime Minister of Turkey since 2003. By restoring order to debt-ridden economies, they gained financial confidence in their once - backward states and laid the groundwork for the boom of 2003-2007, the most powerful and massive in the history of emerging market economies.

All four have managed to transform their economies into engines of growth at an impressive rate. Kim Dae-jung used the Asian financial crisis to audit the country's banks and debt-ridden conglomerates, repaid an IMF loan in less than three years, and as a result, the country emerged from a severe recession in 1998 and grew above 7% in the next four years of his only presidential term. Lula da Silva managed to curb government waste, which helped bring inflation under control, resulting in economic growth rising from 1.5% to over 3% during his first term and exceeding 4% during his second. Erdogan has implemented similar fundamental changes. He managed to gradually rid Turkey of IMF loans, which the country took out almost annually for 40 years. GDP growth exceeded 7% during his first term, but slowed to 3% in his second. But perhaps the most drastic change occurred in Russia, where Putin inherited an economy that had been contracting for five of the previous six years, and the national currency had collapsed twice in the previous 10 years. Not only has Putin stabilized the ruble, but thanks to high oil prices, he has put the country on track for 7% GDP growth during his first two terms as president.

Achievements have made all four reformers market darlings. Restoring Economic Growth, Kim Dae Joon, Lula da Sil-

va, Erdogan, and Putin have all contributed to a stock market boom that has lasted for many years, but these are exceptional cases. However, markets are extremely impatient and turn away from even the strongest leaders if they stop delivering high growth rates, or from the most promising newcomers if they don't perform well in their first 12 to 18 months in power. A similar fate has befallen many presidents and prime ministers, including once-promising figures like Fernando Henrique Cardozo in Brazil, Joseph Estrada in the Philippines, and Junichiro Koizumi in Japan. All of them tried to implement the reforms needed to restore economic growth, but they failed, and the markets punished them accordingly.

WAVE OF HOPE

Stock markets are good at picking up signs of new leaders emerging who can revive the economy, but at the same time they have learned to read the signs of a downturn, which usually follows a period of growth when leaders become too calm and satisfied with themselves to continue with reforms. Over the past 20 years, emerging-market stocks that have been replaced by new leaders have typically returned 20 percentage points above the developing world average during the first term, then moved closer to the average during the second, and fallen 6 points below the average during the third. Third dates are rare, but they show how markets can deal with aging regimes. The latest examples are Erdogan and Putin, former market darlings who allowed growth to slow down after their third ascent to power. Both Turkey and Russia have experienced GDP growth rates of 2% or slightly higher in recent years.

Recent expectations of emerging leaders are driven by the scale of the 2008 financial crisis and the long global downturn that followed. In many of the countries most affected by the economic slowdown, anxiety about the immediate impact of the financial crisis was combined with concern about years of backwardation. These concerns have left voters open to new, determined politicians, and markets ready to reward them.

The first of a recent series of surges in stock market hopes began in the Philippines in 2010, after Benigno Aquino III became president.

the president promised to clean up the country of corruption and debt. The economy soon went from being chronically slow to one of the fastest growing in the world. Next up was Greece, the epicenter of the euro zone crisis, where the stock market more than doubled after Antonis Samaras became prime minister in June 2012 and began implementing tough reforms promised, including cutting public sector wages and jobs. A month later, in July 2012, Mexico saw a sharp upturn following the victory of Enrique Pena Nieto, who took office in December and promised to revive an economy stifled by monopolies. Also in December, there was growth in the Japanese market before and after the election of Prime Minister Shinzo Abe, who intended to implement structural reforms and stimulus measures to wake up the dormant economy.

Then, perhaps the most unexpected thing happened. In 2013, despite Pakistan's reputation as a terrorist safe haven, its stock market suddenly became one of the best performing countries in the world. This was largely due to expectations that the new Prime Minister, Nawaz Sharif, will keep his promises to increase the tax base, privatize state-owned companies, tighten budget discipline, and undertake other economic reforms. So far, despite the ongoing battles with the Taliban, Sharif has kept his word, and investors are rewarding him.

The new reformers are a more diverse group than their predecessors. In the 1980s, most star leaders, such as Ronald Reagan and Margaret Thatcher, were engaged in market transformation. In the late 1990s and early part of this century, Kim Dae-jung, Lula da Silva, Erdogan, and Putin's main goal was to ensure financial stability. The new leaders don't have a clear overall theme. At a time when each country is struggling for a niche in the face of fierce global competition, they use a set of measures aimed at strengthening the economy (reducing public debt, balancing the state budget) and creating competitive businesses (removing bureaucratic obstacles, fighting monopolies). In the Philippines, Aquino has focused on dissociating himself from corrupt and ineffective predecessors - from the authoritarian Ferdinand Marcos and his flamboyant wife Imelda to Estrada, a former action-movie star who proved far less agile as president. Aquino avoids talking about specifics, but when I met him in Manila in August 2012, he talked in detail about the city's water supply projects

and sardine fishing. His honesty immediately became a signal of future changes, and the markets perceive the head of state as a result-oriented technocrat, which is exactly what the Philippines needs.

Abe, on the other hand, promised Japan a serious shake-up. He literally "lit up" the markets in the first 100 days of his premiership with his ambitious plan to stimulate a stagnant economy and increase the potential for long-term growth by overcoming bureaucratic obstacles and ensuring real competition in privileged industries. Peña Nieto came to power in the same month as Abe, but in a more dramatic fashion, breaking a political pact that had prevented his predecessors from addressing Mexico's major economic problems, including the influence of trade unions and monopolies. Within a few months, Pena Nieto managed to pass reforms that significantly reduced the influence of the powerful teachers ' union, as well as deal with the telecommunications monopoly of Carlos Slim, the richest man in Mexico.

Abe started with simple steps to ensure growth (providing cheap loans and devaluing the currency), but so far he has not moved on to more complex reforms in the field of competitiveness (making it easier to hire and fire corporate employees, increasing the influx of migrants). Peña Nieto continues to take tough steps (such as opening up the state-owned energy sector to foreign investors), but it has not yet managed to achieve growth in the short term. Given this, and skepticism about the long-term plans of Abe and Peña Nieto, market enthusiasm began to fall as if on cue in May, when they entered their 18th month in office.

But none of the leaders should be discounted yet. By mid-2014, Abe, Peña Nieto, and virtually all the new reformers were leading economies that looked fairly confident compared to their main competitors. Despite signs of weakening, Japan has been one of the three fastest-growing economies in the developed world over the past two years. Mexico still needs to pick up its pace, but for now, it is among the few developing countries that are expected to grow faster in the next three years, along with Greece and Pakistan. The Philippines has actually outpaced other economies in the world in terms of growth since 2012. After Modi's victory, India's prospects also look optimistic, at least for the next year.

It is too early to say whether these hopes for strong economic growth will be fulfilled in the long term. But the historical pattern is clear: stock market movements do tend to anticipate real changes in the economy. Typically, a country's current stock market valuation reflects the best overall global outlook for its overall growth prospects. And this assessment is based on a common set of economic information collected by local and foreign investors. Recently, markets have taken the emergence of new leaders as a sign of change and often react more strongly to polls or election news than to economic statistics. At the same time, investors are very picky: they can harshly punish calmed-down regimes and handsomely reward new leaders who are willing and able to take a new path with determination.

Permanent link to this publication: