Q&A: Meeting the challenges of geopolitical uncertainty

09-17-2013

Geopolitical risk is a continuous concern for investment managers, particularly those focused internationally. We asked Federated portfolio managers Audrey Kaplan and Geoffrey Pazzanese how they navigate the often unpredictable course of overseas events in pursuit of investment opportunities.  

Q: Conflicts in hotspots like Syria and Egypt are unfolding on a daily basis. How do such events affect your investment process? How concerned should investors be? The Middle East has been in turmoil for decades: from the oil crisis in the 1970s, the Iran-Iraq War in the 1980s, to the first Gulf war in 1990, to the U.S. invasion of Iraq in 2003, and to the Arab Spring (Tunisia, Egypt, Algeria, Syria), which started in late 2010. Given this history, we think investors should be aware and cautious. More specifically, they should inquire of their investment managers about the process they have in place to mitigate the risks associated with events such as the conflicts in Egypt and Syria.

The Arab Spring has triggered a series of changes and awareness about the region that ultimately may be positive for long-term investments. In the short term, disruptive events—whether they involve hot spots like Syria, natural catastrophes as with Japan’s earthquake or comparatively less extreme situations such as the possible government collapse in Italy—all have potential to negatively or positively affect other economies. Therefore, we apply scenario-based analysis to evaluate an event’s potential impact on other investments (countries, industries or stocks). As for the Middle East, the largest and most obvious impact for investors involves the price of energy, much of which is sourced in that region. While none of the global oil/gas supply comes from Egypt or Syria, the conflict embroils other major oil and gas producers near and far. Therefore, investors need to be aware of the countries and stocks whose economies or share prices can be positively or negatively affected by rising oil prices. While rising oil prices are good for investments in Norway, a major oil producer and oil services provider, they are bad for investments in Japan, which needs to import all of its oil.

Because events in Syria and Egypt are regional in scope, it’s important to broadly consider their impacts across the Middle East. Generally, we avoid any direct investment in Middle Eastern stock markets due to continuing geopolitical risks and low liquidity. Exceptions include Turkey and Israel. Both have attractive qualities such as strong political and economic ties to Europe and the West. We are evaluating Qatar and the United Arab Emirates as well.

It’s also important to track non-Middle Eastern global companies that have business in the region, typically in the oil and petro-chemical sectors, or in construction. We handle this by investing in companies that are sufficiently diversified geographically. Further, if these companies have lines of business in hot spots, it is essential to evaluate their ability to manage negative impacts, and potentially exit the area with limited sustainable effect on their assets and financial results. But generally, if a company has a heavy amount of business in a hot spot, and we think conflict could trigger a negative event, we tend to avoid these companies.

Q: China’s transition into a domestic demand-driven economy will affect not only that country but also exporting countries around the world. As China adjusts its policies, what are you expecting in terms of risks and opportunity? China’s transition into a domestic-demand economy will take a few years, not quarters. Currently, it is an investment-led, export-driven economy. Expectations are that during the upcoming meeting of the Communist Party this November, the leadership will reveal its national reform agenda. We expect programs will be rolled out over the next few months. Between 2002 and 2012, China’s real economic output expanded by a whopping 150% in real terms, and more than 200 million people were lifted out of poverty. However, there are still many reform proposals underway, including changing both the household registration system and the one-child policy and clamping down on government corruption.

This year, because of the increasing prosperity of and more robust spending from the Chinese consumer, we have seen strong opportunities in Chinese domestic growth stocks. As a result, investments in select auto and travel-related companies have been among our best ideas. Recently, with U.S. growth improving and Europe in recovery mode, Chinese exports have been growing at a better-than-expected rate. Going forward, our research suggests there is a risk premium embedded in the stock prices that is not justified by corporate fundamentals. The growing prospects of structural reform measures later this year may increase investors’ appetite for Chinese equities.

Q: What else are you currently watching? Is it possible to prepare portfolios for unexpected events? In terms of the so called ‘unknown unknowns,’ the best preparation is to have a diversified portfolio that does not rely excessively on any one investment idea, theme or geography. Considering possible events with a high or low probability—the ‘known unknowns’—it is critical to assess each one and evaluate each on its merits. Some areas we are watching:

  • Brazil In the last two months, there was a rapid sell-off in the currency versus the dollar. At the moment, it looks as if this sell-off has bottomed, but we remain cautious. We are seeing trouble in mining sector companies as their net profits have declined due to a combination of local currency depreciation, reduced iron and other commodity production and lower prices. In the energy space, Brazil’s dominant, quasi-state-owned energy concern is struggling with government-controlled fuel prices that are below the market prices which it must import. It’s also dealing with investments mandated by the government that do not make economic sense. As a result, we are avoiding the mining and energy segments, which we believe will experience negative impacts in the near/mid-term and seeking more attractive growth opportunities in consumer-oriented industries like banking, insurance products and food and beverage retailers.
  • Emerging-market currencies Coinciding with U.S. “tapering” discussions, there was a steep sell-off in emerging-market foreign exchange as foreign investors repatriated assets away from emerging economies back to the U.S. We do not expect further declines as our research indicates emerging economies are better prepared to weather rising U.S. interest rates than in prior hiking periods. We would be cautious, however, evaluating each economy on its own merits. For example, in our view, Indonesia has potential for further trouble due to rapidly deteriorating current account and foreign exchange reserves.

Thank you, Audrey and Geoffrey


 
 
 
 
 
 
 
 
 
 
 
Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.
International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Prices of emerging-markets securities can be significantly more volatile than the prices of securities in developed countries, and currency risk and political risks are accentuated in emerging markets.
Federated Global Investment Management Corp.
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