Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

When investors talk about stock investing, they mostly talk about the small questions. Which way is the market trending? Where are we in the market cycle? (Insert your favorite piece of financial punditry here.)

Those questions may be entertaining, and a prescient investor might even profit from the right answers, but investors are probably no worse off -- and may even be better off -- if they tune out those conversations entirely.

The recent coup attempt in Turkey, however, raises a pivotal question that every stock investor must confront: Will Turkey continue to respect a rule of law that bolsters free enterprise and vibrant markets?

Sell Now, Ask Later
Turkey's government insists that it's business as usual despite recent emergency measures, but investors seem unpersuaded.
SOURCE: Bloomberg

Early signs aren't encouraging. President Erdogan has imposed a state of emergency, and Turkey’s parliament handed the government emergency oversight yesterday, effectively allowing Erdogan to impose martial rule. Mass imprisonments and a civil service purge have followed.

The state of emergency is expected to last several months, and Deputy Prime Minister Mehmet Simsek has tried to reassure nervous investors that “business will be as usual” and that Turkey remains “committed to the market economy.”

But investors don’t seem reassured. The Borsa Istanbul 100 Index has dropped 14 percent on heavy volume since last Friday. More telling, the Index has declined every day this week despite the fact that the coup was squashed last weekend and well before Turkish stocks began trading on Monday.

Investors, in other words, aren’t bothered so much by a failed coup as about what comes next. Their concerns are well placed -- there’s good reason to believe that weak rule of law is associated with greater risk for stock investors.  

Turkey is one of eleven emerging market countries – along with Brazil, Mexico, Philippines, Indonesia, Thailand, Malaysia, Greece, Taiwan, Korea and Chile -- with an MSCI stock index that stretches back to 1988 (other emerging market locales have later inception dates).

So I compared the historical return and standard deviation of each legacy MSCI country stock index with that same country’s average rule of law score from 1996 to 2014 (as compiled by the independent research firm The PRS Group). Rule of law scores are given on a scale from zero to one, with one representing the strongest rule of law. (Standard deviation is a common market proxy for risk that measures the volatility, or bumpiness, of investment returns).  

What I found was that the correlation between the countries’ rule of law scores and the standard deviations of their stock indices was a negative 0.24. In other words, weaker rule of law is correlated with greater stock market volatility, and vice versa.

Brazil, for example, had the lowest rule of law score (0.35) of the eleven countries, and the MSCI Brazil Index had the second highest standard deviation (50 percent). Chile, on the other hand, had the highest rule of law score (0.81), and the MSCI Chile Index had the lowest standard deviation (24 percent). (To put this in perspective, the S&P 500 and long-term U.S. government bonds have had a standard deviation of 19 percent and 8 percent, respectively, since 1926.)

Risk and return go hand in hand, of course, so it’s also true that weaker rule of law is correlated with higher returns, and vice versa. The correlation between the countries’ rule of law scores and the annual returns of their stock indices was a negative 0.5.

Mexico, for example, had the second lowest rule of law score (0.38) of the eleven countries. The MSCI Mexico Index returned 17.1 percent annually from January 1988 to June 2016 (including dividends), handily beating the return on the MSCI Emerging Markets Index of 10.6 percent annually over the same period. But risk cuts both ways. The Philippines had the third lowest rule of law score (0.43), and the MSCI Philippines Index returned only 8.6 percent annually over the same period.

Rolling the Dice
Weak rule of law is associated with higher expected risk and return. Here's how that bet played out for stock investors in Mexico and the Philippines.
SOURCE: MSCI

All of this brings us back to Turkey, which at first glance looks like an outlier. Turkey’s rule of law score (0.67) puts it near the middle of the pack, but the MSCI Turkey Index had the highest standard deviation (54 percent!) of the eleven countries. What gives?

It turns out that Turkey hasn’t been a model of stability when it comes to rule of law. Turkey’s rule of law was weak in the 1990s, and the rolling ten-year standard deviation of the MSCI Turkey Index was upward of 60 percent back then. In the 2000s, however, Turkey’s rule of law strengthened, and the Index’s standard deviation drifted down to just below 40 percent, where it remains today.

But here’s the most important thing to note, I think: Turkey’s rule of law has been weakening since 2010, and its annual rule of law score was lower in 2014 than at any point since 1996. It’s hard to imagine that Turkey’s rule of law scores won't continue to weaken even further following this week’s developments.

The upside for investors is that Turkish stocks will have to extend the carrot of higher expected returns to investors to attract them -- and investors will have to decide whether the risk is worth it.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in Washington at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Timothy L. O'Brien at tobrien46@bloomberg.net