Dubai: No matter what decision we face in our lives, there is always some type of risk involved. Even something as simple as trying a new food carries the risk of indigestion, whereas not trying it could mean missing out on a new taste sensation.
Commit to a decision and you run the risk of it having been the wrong one. Fail to commit to a decision and run the risk of watching a success pass you by. So, how do you know when to jump in and when to hold back? If you’ve read this blog more than once, you probably already know what we think the answer is: roll up your sleeves and do the homework!
An educated approach is crucial to help determine whether the potential reward outweighs the potential risk of any given choice. Every investment decision carries unique risks, and while many investors think of emerging markets as a risky place to invest, a look at what’s happening in the Eurozone right now proves just how dynamic risk can be. Close monitoring on a country-by-country and company-by-company basis is crucial.
Investors may be quick to associate political risk with emerging or frontier markets, but every country in the world faces some degree of political risk. When administrations change, for instance, policies can change, affecting the investment landscape and market outcomes. Sometimes, these changes can be a good thing. Recent events such as the Arab spring in northern Africa and the Middle East in 2011 and the post-election reforms in Myanmar this year could bring investors interesting new opportunities.
As I regularly visit countries many investors would deem “risky” due to an unstable political climate, people often ask me about it. I have referenced Pakistan as an example of why many investors have a heightened perception of political risk in emerging markets. Headlines coming out of Pakistan could easily lead investors to flee. However, sometimes the media can make a situation appear worse than it really is, creating a cycle of negative investor sentiment which can cause markets to decline further than, in many cases, we think company-specific fundamentals dictate.
That’s one of the reasons we visit so many countries, so we can see with our own eyes what’s going on.
Modern portfolio theory defines risk as volatility calculated by the variance [as measured by the correlation coefficient] of a portfolio’s historical returns. In simple terms, it means a portfolio that is yielding excellent returns may have a high risk profile, if those returns have been volatile over a span of years. Emerging markets can certainly be volatile, but then, so can developed markets. The financial crisis and subsequent credit crunch we saw in 2008-2009 stemmed from developed, not emerging, economies. And some of the developed countries currently grappling with debt problems in the Eurozone certainly look riskier than some emerging markets, which generally have much lower debt-to-GDP ratios. For example, in 2011, Indonesia’s debt-to-GDP ratio stood at 24.5 per cent while Italy’s hit a record of 120.1 per cent. Food for thought.
The root cause of volatility is often uncertainty, which all too often leads to fear and over-reaction. Unforeseen circumstances can become catalysts for greater changes in the global landscape, and the markets have to continually adjust. The upside of this volatility for investors is that fear and panic can bring bargain prices for those with a long-term focus.
Liquidity (or rather, lack of liquidity) can play a key part in creating volatility, particularly in emerging markets. If there aren’t enough participants in the market and liquidity dries up, that can dramatically intensify a market correction. All markets have faced corrections, albeit some more severe than others. We cannot predict when the next correction will occur in any particular market and we accept that market volatility is simply a fact of investing life.
Currency risk relates to the impact on an investment due to fluctuations in the national currency. We’ve seen many examples of currency crises throughout history (I’ve already mentioned a couple here).
So what does a currency devaluation mean to me as an investor? It doesn’t necessarily mean I’d be running for the exits. In some cases, a devalued currency can be an engine for future growth. A lower currency price means the nation’s exports will be more competitive (less expensive) in the global market, and imports will become more expensive, so many companies can benefit.
A discussion about currency values should include a discussion about inflation, which is closely interconnected. Inflation has been problematic for many emerging economies, and while it does seem to be ebbing temporarily in some markets, it’s important to remain vigilant about it. High inflation can cause a strong public response (even a mass uprising), as consumer purchasing power quickly erodes. As I’ve said in a previous blog post, it’s a delicate balance for many countries between stimulating growth and risking inflation.
— The writer is the executive chairman of Templeton Emerging Markets Group.