As chief strategy officer at PGIM, Taimur Hyat, PhD, has had a front-row seat to a critical shift in financial markets
In the years immediately following the financial crisis, the primacy of central banking and monetary policy held sway. Terms like quantitative easing (QE), taper tantrum, and zero interest rate policy (ZIRP) entered the investor’s lexicon and came to define the era.
But sometime in the last several years, something changed. In our interview below, Hyat refers to it as “a twofold shift in what investor discussions focus on.” One aspect of that shift has been a renewed concern about geopolitical risk.
This transition is not altogether unanticipated. As Pippa Malmgren observed back in 2015 in Geopolitics for Investors, published by the CFA Institute Research Foundation:
“The era of globalisation not only brings greater interdependence in terms of both the global economy and security but also makes it impossible to disaggregate risk in a way that might have been possible in the past.”
Whether it’s the United Kingdom’s Brexit vote, the focus on immigration and border walls in the 2016 US presidential race, the outbreak of tariff wars, or the rise of increasingly nationalistic and euro-skeptic movements throughout the EU, geopolitical considerations have taken on ever greater importance and signaled the emergence of a complicated new phase in international affairs and global financial markets.
This reaction represents globalization’s counterrevolution, and while globalization can’t be rewound, how it and the risks and opportunities associated with it evolve will be influenced by this reaction.
Indeed, the Future State of the Investment Profession, published last year by CFA Institute, envisioned one potential scenario:
“Geopolitical instability connects with social instability and produces deeper inequality fissures; negative feelings deepen around job fears, immigration, inequality, and getting a fair share of a nonincreasing pie.”
While such a scenario isn’t inevitable or necessarily even likely, it is a real risk and one that investment analysts would be well-advised to price into their models. How to do that is one of the questions we addressed in our discussion with Hyat. Below is a lightly edited transcript of our conversation.
CFA Institute: How much attention do investors pay to geopolitics now? Did this investment paradigm change?
Taimur Hyat, PhD: There has been a twofold shift in what investor discussions focus on. Five years ago, the primary topic was monetary and central bank policy. Now the conversation has shifted to tax policy and what’s happening on the fiscal side with discussion on government budgets in the US and other countries.
The second new topic of discussion has been the importance of geopolitical risk. It has moved much higher up the list of topics investors want to cover, both in the run‑up to the US election and, indeed, even beyond that given events such as the change in the US administration, Brexit . . . It really has moved up the list.
One other point I would add is that the nature of the geopolitical risk discussion has shifted as well. Instead of it being purely an emerging market geopolitical risk issue — for example, what will elections in Pakistan mean for its future — now investors are seriously considering risks in the developed markets, such as the political outcomes in the US, UK, and Europe, and what they mean for the global economy.
To sum up, the change we are observing is both the importance of geopolitical risk to our clients and where that risk is coming from.
Despite these shifts, many investors just focus on the bottom‑up analysis. Of course geopolitics matter, but from an investor’s perspective, it is impossible to price in the tug of war between short‑term noise amd the longer term signal. What do you say to the doubters?
A couple of thoughts.
First, the tug of war: Here at PGIM we strongly believe that in the long term the forces of globalization are powerful enough in terms of the benefits from trade and sharing intellectual capital and ideas that globalization is and will continue to win.
In the near term, however, some of the risks created by globalization have caused a fair amount of angst and that has led to the rise of strong nationalist movements. There will be a tension, and, indeed, every time in history when the forces of globalization have been stressed by more nationalistic impulses, there’s been a significant heightening of geopolitical risk.
I do think we are going through that right now. This is not contradictory to the idea that globalization will eventually prevail. In fact, it proves the hypothesis that we are living at a time when nationalistic forces and their tug of war with globalization can cause a lot of near-term volatility.
That is completely consistent with the idea that in the long term we still think we and our long‑term investors should be placing our bets on globalization winning.
To the second part of your question . . . can you just ignore these near‑term geopolitical risks, because they’re too hard to predict? I think investors are increasingly discovering that you simply can’t afford to do that.
Let’s consider Brexit, where many of our clients were left scrambling to understand their true exposure . . . It’s easy to look at your direct UK equities holding, but what is your real estate holding? And do you indirectly have exposure to the UK economy through companies that may be earning a significant share of their revenues there?
We would argue not being able to understand your geopolitical exposures really puts the chief investment officer, or any investor, in a fairly uncomfortable position in terms of being able to speak to what their portfolio represents.
Embedding geopolitical risk in valuation is of course far from being a new idea. I would think most of the CFA charterholders would agree that looking at geopolitical risk in the emerging market context has always been important, which is why they look at sovereign credit rating risk, and why they have specialist analysts devoted to emerging markets.
Our extension of that chain of thought is that if the focus of geopolitical risk has expanded beyond emerging markets to developed markets, it’s only logical that in‑house asset allocators as well the third-party asset managers begin to shift their focus. Now they must also analyze new geopolitical risks from where they are emanating, which is increasingly developed markets.
One issue I grapple with in integrating geopolitics into investment analysis is the problem of scale. A smaller market is far more contained: You can “put your arms around the risk.” That’s much hard to do in the US or UK context. How do you do it? Are the spillovers from huge interdependent flows of goods, capital, and people too complex to analyze?
It’s a fair point. I think it leads to two ideas. One, as we, I think, layout well in “The End of Sovereignty?”: It’s extremely hard to think across the portfolio without an integrated global framework. As you said, the spillover effects are just so powerful.
You can’t really think of the S&P 500 as US exposure or the MSCI Europe Index as European exposure. For example, 50% of the revenues at the MSCI Europe index comes from outside Europe. However, this reinforces the point that investors need to think globally even if they invest in purely domestic portfolios.
You can’t analyze regional exposures in isolation. Say I’m getting my US exposure from an active asset manager benchmarked to the S&P 500 or I can get my European exposure through an MSCI European indexes. There’s too many interlinkages between these countries to not have a global framework in terms of analyzing what your true exposure is to global trends.
The second point I’d make is that it is ironic to even talk about the spillovers in the developed market context. For a long time, this type of discussion centered on the emerging markets. The thinking was if one EM country sneezes, all of them catch a cold.
That’s proving to be less and less true, as you see in cases like Turkey and Argentina, which have some fiscal issues to contend with, versus several Southeast Asian EMs, which are in a much stronger fiscal position. Overall, I’m not sure where contagion is more of an issue now, in the EM, or in the developed markets.
We would also argue that there are some investment opportunities that are more resilient to G8 geopolitical risk than others. I think a good example is companies whose primary revenues come from, for example, EM-to-EM trade.
If you think of a Thai motorbike company exporting to the rising middle class in Cambodia and Vietnam, you really have a self‑contained firm that doesn’t need to rely on the vagaries of trade talks between G8 countries and ASEAN to figure out the value of this investment opportunity.
We do therefore think it’s important to understand what is the resilience of a particular security that’s been selected, a particular trading strategy that’s been adopted, a particular real estate or infrastructure asset that’s been acquired, and these geopolitical risks. We would argue, certainly in the EM example I gave, there are places where you can be more resilient.
In the US context also, you could think about what opportunities that are more resilient to the tit-for-tat trade negotiations and are more reliant on domestic US consumption. Those might afford a bigger opportunity if you start taking geopolitical risk and playing out the game‑theoretic analysis of where that might or might not lead.
Is your suggested approach to managing the global volatility to be more local or regional?
I would state that a little differently. I would say when you incorporate developed market geopolitical risk into your investment frameworks, you arrive at different investment conclusions sometimes than if you did not. Depending on the scale of the risk and the length of the investment, it may lead you to look for investments that are more resilient to that developed market geopolitical risk. I think one example of that would be EM-to-EM trades. I’m not sure it’s necessarily local, but it’s relatively resilient to global volatility.
How does this apply to large institutions, which almost have no choice but to be “universal” asset owners across all asset classes?
Regardless of whether you have an in-house investment team or use a third-party asset manager, you’ve got to understand how they are incorporating political risk into the portfolio, and what different decisions they are making as a result.
At the same time, it is very important for long‑term investors to separate political theater from true political risk. In many cases, the bark is worse than the bite. The art is to separate this from real geopolitical risk, and explicitly capture the impact in the investment framework.
I think when you do that then you find that within each sleeve of your portfolio, you may make different decisions in terms of what kinds of firms you think are more resilient to changing geopolitical orders.
As another example, right now the technology sector is almost the Trojan horse in global trade wars. Especially so given all the intellectual property discussions underpinning trade, and of course, given the growing focus on privacy within many governments.
Therefore, there is a decent probability that the technology sector will face greater regulatory risk than others, whether it’s through trade regulations, or direct EU‑style regulations. Not taking that into account as you think about your technology investments will probably create a pretty significant gap in your investment framework.
This approach is fairly new. Developed country geopolitical risk, whether it comes from regulatory sources, cross‑country trade sources, or nationalist firms having either anti‑migration or anti‑trade agendas is all fairly novel. I don’t think this was at the center of how investors invested five years ago.
Let’s go down the technology sector rabbit hole a little bit. Given the trends you identify, should investors incorporate a country risk overlay on top of their policy portfolios? Is that practical to naturally offset or hedge these risks?
It’s a good question. I think you could think about hedging, although you have to think really carefully about the cost of those hedges, as well as how they would perform under true geopolitical stressed scenarios.
I think our most practical suggestion is employing in‑house political risk teams alongside your traditional economists looking at market and macroeconomic risk, to understand different geopolitical events, and how they might affect portfolios.
I think the second practical suggestion — again, more in terms of process than a particular single short-term idea — is really doing scenario analyses. To your point, geopolitical events are often tail risk‑driven, rather than amenable to classic VaR risk frameworks.
Perhaps conducting scenario analyses to better understand how a political or geopolitical event, if it unfolded, might affect portfolios, and how one might respond, could be a good addition to the risk discussion.
Again, Brexit is probably the best recent example where most of our investors were not ready with an answer when the voting results came out to understand, “What does this even mean for my portfolio?” and therefore am I overexposed or underexposed to the kinds of risk that Brexit might impact.
There were a lot of expert predictions on how dire the Brexit outcomes will be. Not too many in‑house political teams got those calls right in either magnitude or timing. What’s the best way of measuring the effectiveness of “political risk alpha” in the investment portfolio context?
Political forecasting has been quite challenging recently so I don’t think investors can put too much weight on hoping the pundits get it right. Instead, I think being prepared with responses to different geopolitical scenarios is key.
We would argue that investors should really try and understand their true region‑specific exposures to different scenarios that might unfold.
Understanding your portfolio sensitivities to geopolitics in that manner has become imperative. This includes your exposures to developed market sectors such as technology or countries where there’s a lot of upheaval. Without doing this analysis investors can’t really understand the geopolitical risks embedded in their own portfolios.
That’s a separate issue from, will Brexit turn out to be worse than they expected or less worse. If you can’t analyze what it means for you, it’s irrelevant which worldview you believe in.
Makes sense to know what you are potentially exposed to.
The way to assess this is by incorporating political risk teams and scenario analysis in the investment process.
Separately, I’m not sure whether there’s necessarily a role for geographic revenue-weighted indices that MSCI, Russell, and other index providers create.
I do think that it is a step in the right direction in terms of risk analysis, even if it’s not necessarily an investment index. By that, I mean asset owners and asset managers should help companies be more transparent in disclosing their revenue’s geographic distribution and, also, where their labor force is based. Where are their factories based? What is the geographic distribution of their inputs? What is the geographic distribution of their sources of financing? What is their region‑specific economic exposure in terms of clients?
I think that transparency will help improve and enhance the analysis that institutional investors can then do to determine their true exposure. This is essential, not so much to invest behind the indices constructed on these exposures, but in terms of doing the kind of scenario analysis we discussed, and better understanding the risks associated with different kinds of geopolitical events.
Scenario assessments of geopolitical tail risks make sense as investment analysis tools. Why is this suddenly front of mind? Brexit and trade negotiations are not new. What has changed to cause such great anxiety?
What we are getting now is a much greater backlash against globalization. The magnitude of political transformations over the last 36 months are significantly greater than the 360 months prior to that.
If you look at the change in the direction of the US administration in pulling out of the TPP [Trans-Pacific Partnership], the Brexit results, the rise of nationalist parties that have never been in power in Italy, we are in a quite different environment. These events make me less convinced that “nothing has changed.”
In fact, we would argue that developed markets political risk has risen dramatically as a result of this backlash against globalization. It is far higher on our clients’ agendas. Rightly so, because it is a far more real‑time risk now, compared to a more stable international geopolitical and trade order previously.
What advice do you have for a large institutional asset owner with a typical home-biased portfolio in a developed market that is experiencing heightened political risk? Say a UK pension fund or an Italian insurer that suddenly find its portfolios in the eye of the storm?
One, I would say decrease your reliance on top‑down country‑level factors as the primary way that you analyze equity, real estate, or corporate bonds. You will find that in the raw data, the decomposition of returns means there’s less weight to country, more weight to sector, stock‑specific, and other global trends. So it is important to be less reliant on a top‑down, country‑specific way of allocating out your portfolio, and then making security‑level decisions. Instead focus on a much more global framework given the degree of cross‑country spillover effects in driving prices within a single asset class and, indeed, across asset classes.
Of course, you may still hire managers or in‑house teams that are focused on particular regions. If you have a good handle on the aggregate data that incorporates the spillover effects across countries, you will know what your exposure to the UK or Italy really is. Are the revenues of that company really coming from the UK or Italy? Where is your cost coming from? Where is your true economic exposure?
Because of the degree to which global trade and global supply chains are interconnected, you will probably need to capture all that. Understand where and what you are exposed to, rather than relying on the somewhat misleading nature of what an index driven by a listing’s domicile might suggest.
You have called out a number of important investment process improvements. Do we need new tools?
I think you can go a lot of the way with the analytical tools that already exist, such as the same frameworks that we use for EM political risk, applying them to DM.
These new issues, instead of requiring new tools, require a new way of thinking. One is the nature of the disembodied modern firm where global supply chains, digital technologies, and the ability to transfer code and work seamlessly across borders means that the country of origin has become increasingly hard to think about as a useful concept.
We’ve got to come up with new ways of thinking. Where is the value being created by geography, by sector, by design, and brand? For example, so much of the value of a smartphone is in design. Where is that being captured? I think the tools of GDP and investment analysis are perhaps a little antiquated, but that’s where technology has taken that discussion.
The second piece here is trying to figure out better ways of mitigating tail risk, especially the geopolitical tail risk. As you know, broad overlay hedges are quite expensive when it comes to mitigating geopolitical risks. Are there other ways to think about tail-risk hedging strategies? More generally, are there approaches to volatility management that go beyond economic risk to political risk?
You were right at the beginning to challenge us that not a lot of political risk hedging solutions reside with either the buy-side or the sell-side, but I think that doesn’t mean that there aren’t any that could be developed. I think that it means that maybe we need to think more in an era where those risks have, at least in this part of the cycle broadened, what can you do to properly evaluate these risks just like we evaluate counterparty risks or market risks.
Some asset owners are themselves becoming the agents of change, taking stands on global issues be they environmental or social. What are the advantages and pitfalls of such asset owner activism?
You’re absolutely right. Asset owners are being seen as key players in addressing cross-border challenges and opportunities such as climate change and cybersecurity. Civil society often expects large asset owners to have a point of view on issues that may go beyond where the CIO has traditionally been comfortable focusing on. For CIOs, the challenge is to balance advocacy and take points of view on global challenges without undermining fiduciary duties to the pensioners or to their clients in optimizing investment returns.
Having said that, I think we would argue that a modern civil society is increasingly asking asset owners to have points of view on cross‑country challenges, particularly in a world where the country unit itself, for all the reasons we argue in the report, is less relevant in addressing these challenges.
Any recommendations on how this geopolitical megatrend should influence institutional asset owner’s decision making?
Be mindful that the rumor of globalization’s demise is greatly exaggerated. The near‑term political backlash against globalization may indeed be a very bumpy ride as the struggle with nationalist forces plays out.
However, if you take a long‑term view, while being prepared for that geopolitical tug-of-war, it’s important to recognize that the economic forces underpinning globalization are powerful. In addition, whether you are investing in equities, real estate, or corporate debt, do not consign the discussion of geopolitical risk only to emerging and far-flung frontier markets. It is critical to embed developed market geopolitical risk in investment decisions. A global framework is essential for investors because the spillover effects are just so powerful, regardless of what politicians might say or attempt to do in terms of limiting trade or migration. The world is more connected than ever before.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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