“Geopolitical issues are becoming more important, because how can you understand [the] economy if you don’t understand geopolitics? People think economists just deal with spreadsheets and charts. That’s a narrow-minded caricature.” — Nouriel Roubini
As chief operating officer at PGIM, Taimur Hyat, PhD, oversees global strategy and institutional advisory solutions across $1.2 trillion in assets under management (AUM). Last summer, he spoke with us about the renewed need to integrate geopolitical risk considerations into investment analysis. In the months since, his observations have come to look increasingly prophetic.
With sustained populist sentiment continuing to disrupt and upend long-established political hierarchies throughout the globe, Hyat was clearly on to something.
And now, as Brexit negotiations have morphed from dialogue to debacle in the face of forthcoming deadlines and nuclear-armed neighbors India and Pakistan once again confront each other across the Line of Control, the present seemed like a propitious time to catch up with Hyat.
Below is a lightly edited transcript and video recording of our conversation.
CFA Institute: To follow up on the discussion we had roughly six months ago on the risks of geopolitics in investments, Brexit and Europe have moved on with it and we stand on the cusp of large changes. Has the landscape been permanently reshaped?
Taimur Hyat, PhD: I think the landscape has been permanently reshaped, and our report foreshadowed things that have only exacerbated, particularly in Europe since we last chatted about this. If anything, political risk in developed markets has become even more central to the analysis that our investors and our portfolio managers need to do to understand the true long-term potential in any asset that they look at, whether it’s fixed income, equities, or real estate.
How should investment organizations think about tracking their exposure and mapping it to the various risks?
This all became very real with Brexit when we had investors scrambling to understand their true exposure to the UK and their true exposure to Europe. You had the MSCI Europe Index, where over 50% of your exposure is not actually to Europe and similarly with the UK. It wasn’t just direct equity. It’s what happening within debt. It’s what is our real estate exposure. It was very hard for investors to figure out what their true exposure was to Brexit, and I think that was the wake-up call in terms of these complex relationships you mentioned.
We would urge all investors to spend much more time than they currently are spending really trying to unravel what are the first- and second-order effects that truly result in the exposure to a particular trend or a particular country. I think one of the key things investors can do here is actually work with companies to really improve their disclosures. It’s really hard to unravel the supply chain, the vendors, the debtors of a company and understand what is the true exposure of a company, maybe headquartered in Germany or headquartered in Seattle. But what is the true underlying client base and vendor set that is creating real exposures for this company?
I think investors can play a key role in really accelerating the exposure of that information and getting more transparency around that.
Pulling on that thread of disclosure, what are the best practices you are seeing nowadays in how investment organizations can actually work with the CEOs of those companies that are producing information for the analysts?
I think there are two pieces here. One, I think investors can really encourage companies around the world to give much more detailed disclosure around what their country risks are in terms of not just their client base but also where their vendors are, where their debtors are, what are the indirect exposures that they have.
The second key thing for investors to do, or for their third-party managers, is really to make political risk analysts and political risk analysis integral to how they think about investment decisions.
None of the old levers changed. You still have to see what does pricing look like, where in the cycle you are, what are the macroeconomic indicators. But another equally important dimension that’s now been added, even to G–8 investments, is what’s the political risk analysis?
The end goal is to spot tail risks, those kind of events that are incredibly hard to forecast but incredibly influential. Are there any particular areas around the globe that you’re watching for, any catalysts, any signs, of those tail risks emerging?
First of all, you’re absolutely right. The sort of classic VaR-based models that you have for looking at asset-pricing risks really don’t work with political risk. A lot of the key political risks are tail risks, and they are pretty binary. Do India and Pakistan go to nuclear war or not? What happens in the North Korea and US negotiations? What happens in the South China Sea? These are binary outcomes, and your classic risk-based models, which economists are used to, really don’t work that well in this setting.
So, I think tail-risk analysis and scenario analysis and gaming out different scenarios and seeing what does that mean for my portfolio and understanding what it means for my exposure is pretty critical in this setting.
I think in terms of tail risk that we see, clearly some of the tensions in South Asia would be one. I think what happens in China, not necessarily a tail risk, because we do think that it’ll return to maybe not almost 10%-type growth rates, but they will definitely have higher growth rates than developed markets, but the speed of the slowdown, whether there’s a risk from corporate leverage there to have some kind of economic shock that the government and macro policy can’t fix quickly enough. I just think the behavior of politicians around the world and what kind of trade or other risks come from that — all those are risks we are looking at.
It’s not one big tail risk. It’s lot of politically driven risks that will add up and accumulate and exacerbate each other in ways that the markets are feeling very vulnerable to right now.
Let’s give CIOs some tools. What should they be doing?
A few things. CIOs first of all should continue to invest globally but think regionally. And really think about, what are the political risks in different countries? And gather all the third-party sources that give a pretty rich account of what’s happening in different countries.
Second, these third-party sources, while valuable, are mostly backward looking. We would really encourage CIOs to talk to either their third-party asset managers or in-house teams that look at political risk and analyze that with a forward-looking view. What’s coming next?
And third, I think CIOs need to spend much more time in data analytics and understand their true exposures by unraveling behind the headline, behind the company, what is the true set of country exposures that they have.
Emerging markets, whether on their own or as a feedback loop from developed markets, can arguably be prone to larger movements. How do you think about that?
EM political risk has not gone away at all. It’s really that the developed markets have caught up with EMs, rather than that EM political risk has changed. It’s high. I think some of the nationalistic movement that we talked about in our paper, “The End of Sovereignty,” have also extended into EMs, perhaps in a deeper way than six months ago. I’m thinking of Brazil, for example, and some of the discussions in Mexico.
The key thing in EMs that’s really changed that CIOs need to take account of is that emerging markets aren’t really a monolith. So when you look at risk in Turkey or Argentina, it really doesn’t bear much weight in what’s happening in, for example, Indonesia or Vietnam. And China of course is an entity unto itself with its own influence. But thinking about emerging markets as separate countries and as separate trajectories and, increasingly, their domestic demand-driven growth engines, whether it’s the middle class or EM to EM trade, that is what’s become critical there.
Thank you very much.
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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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Paul Kovarsky, CFA, is a director, Institutional Partnerships, at CFA Institute.
Paul McCaffrey is the editor of Enterprising Investor at CFA Institute. Previously, he served as an editor at the H.W. Wilson Company. His writing has appeared in Financial Planning and DailyFinance, among other publications. He holds a BA in English from Vassar College and an MA in journalism from the City University of New York (CUNY) Graduate School of Journalism.