Managing the known unknowns
In a normal environment, known unknown risks can be managed tactically using a variety of hedging strategies. For example, an investor may want to be a long-term holder of a particular emerging market stock based on the merits of the company. But the investor may have concerns about an imminent election that could adversely affect the investor’s perception of the country’s prospects. Since stock prices tend to be highly correlated within an emerging market, it’s unlikely that the investor’s stock would thrive, however strong the company’s fundamentals. Selling the stock and repurchasing it after the election would involve high costs, particularly since the sale would be made in markets nervous about the election and the repurchase made in a rallying market relieved that the election went well. There is still only limited opportunity in emerging markets to hedge using stock options. Instead, the investor can relatively easily and cheaply achieve some degree of protection by using forward foreign exchange contracts, effectively eliminating the local currency exposure and swapping it for, say, the investor’s base currency. Currency markets are generally the most sensitive to changing perceptions of political risk and can, therefore, be a very effective hedging instrument in these circumstances.
Some investors have responded to the current policy-driven environment by adding policy analysis to their research arsenal—in some cases, hiring outside consultants (usually ex-politicians). But the value of this as anything other than a marginal risk management tool is questionable.
It is hard not to feel that much of what we’re seeing in the policy environment is likely just “noise” for a long-term investor. Efforts by governments to fundamentally alter the trajectory of their economies are increasingly constrained by fiscal and monetary circumstances and, in the end, are likely to be less significant than the global structural changes under way: the known knowns.
Known knowns
“The things we know we know,” said Rumsfeld. It would normally be bold to claim that there are many things we know with certainty about the future. However, despite the short-term policy risks described above, there seems to be an unusual degree of structural clarity in the global economy on which investors should focus.
The structural economic imbalances in trade and capital flows that have developed over the last few decades seem to have reached a natural limit. They were a major contributor to the recent financial crisis and are continuing to destabilize the global economy, undermining efforts by individual economies to stimulate growth. The process of rebalancing has started, not because of any global agreement or policy initiatives but only because most deficit countries (particularly the U.S. and the U.K.) have reached unsustainable levels of indebtedness and face a prolonged period of weak domestic demand. Real progress will not be made until the surplus-generating countries (particularly China and Germany) come to realize that their mercantilist policies are ultimately self-defeating and need to be abandoned in favour of policies favouring domestic consumption.
Managing the known knowns
It is inevitable that a rebalancing will gradually take place. This process will involve a number of powerful trends that have a high probability of occurrence but which seem to be underestimated in today’s markets.
Perhaps the most significant trend is that emerging markets are going to increase their share of global economic activity, income and wealth. Rebalancing will, of course, put pressure on their export performance. However, since the financial crisis and its negative impact on exports to the developed world, many emerging markets have already made impressive policy shifts toward bolstering domestic consumption. Consumer-focused companies within emerging markets, particularly staples, are likely to see very high growth rates in coming years. Global consumer companies based in developed markets are already experiencing strong sales growth, particularly if they have established brand identities and distribution arrangements.
At the same time, emerging markets have substantial policy latitude to provide stimulus, both fiscal and monetary, to their economies, if needed—in stark contrast to developed countries. This situation was, in fact, one of the goals of Asia’s emerging economies coming out of the crises of the late 1990s: to generate surpluses so as to avoid dependence on foreign capital.
In the developed world, in contrast, the impact of the rebalancing process will have a much more muted impact. A combination of high debt levels, fiscal deficits, aging populations (with underfunded pensions and healthcare) and labour costs that remain less competitive than emerging markets will combine to keep both consumption and investment weaker than markets seem to be pricing in. Japan’s frustrating experiences of the last 20 years are beginning to look more relevant as a guide to the future for other developed economies.
Political and geopolitical risks, broadly defined, will remain elevated for the foreseeable future. Investors will do better to tune out the headline noise created by the interplay of short-term events and policy actions that is driving markets today. Rather, they should focus on positioning their portfolios to benefit from long-term global trends, many of which have a higher-than-usual degree of certainty around them. This might result in high volatility in returns relative to a passive benchmark but should lead to stronger long-term results.
Andrew Barker is senior portfolio manager, international equities, with Artio Global Management LLC. andrew.barker@artioglobal.com
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