For investors, an assessment of country risk should seek to answer one key question: is the country under review an acceptable investment destination? If the answer is no, why would you invest there?
Key Takeaways
- It is not just major, high profile, macro events such as war or a global financial crisis that can impact country risk
- Sometimes risk deterioration can be a far more subtle, almost a creeping, incremental event – a product of longer-term structural decline
- Detailed country research helps build a strategic outlook, identifying relative country strengths and weaknesses, aiding stock coverage, and portfolio level sector and demographic exposure
Sarah Shaw, chief investment officer, 4D Infrastructure, explains why investors need to consider country risk.
Country risk is real and shifts over time both in a positive and negative direction which can impact stock investment decision making. The current Russia/Ukraine war is the most recent demonstration of country risk, highlighting the very real impact it can have on companies and ultimately on investors. Russia has been severely sanctioned by the international community as a result of its actions in the Ukraine, which has had a material impact on Russian companies and any international companies operating there, as well as their investors.
At a global level, the global financial crisis (GFC) from 2007-2008 provided a demonstration of country risk in practice. Prior to the recent COVID-19 recession, the GFC was considered the most serious financial crisis since the Great Depression in the 1930s. Using changes in a country’s long-term Standard and Poor’s (S&P) credit rating as a proxy for changes in country risk, it is clear that some nations really struggled during the GFC – none more so than Greece, which went from a solid S&P investment grade rating of ‘A-/A+’ pre the GFC to a virtually uninvestable ‘C’. Now that is country risk deteriorating rapidly! Fortunately, Greece has exhibited a gradual recovery since then.
But it is not just major, high profile, macro events such as war or a global financial crisis that can impact country risk.
Sometimes risk deterioration can be a far more subtle, almost a creeping, incremental event – a product of longer-term structural decline.
For example, there has been a gradual rating decline for Japan during the 21st century, although it remains in the investment grade ‘A’ category. Deteriorating national demographics and excess levels of public debt have been important factors in this gradual rating erosion.
Similarly, but more quickly, the UK rating deterioration reflects its decision to exit the European Union, following a narrow referendum result in June 2016.
Of course, changes in country risk can also be positive. China’s rating history clearly reflects its economic and social growth and advance during the 21st century, with a steady rating climb since the early 1990s.
Finally, some things just ‘seem right’ over the long term, as reflected by Germany’s rock solid ‘AAA’ rating history and the almost rock-solid history of the US.
For investors, an assessment of country risk should seek to answer one key question: is the country under review an acceptable investment destination? If the answer is no, why would you invest there?
Our own country review process starts with a Preliminary Grade based on a country’s S&P long-term credit rating.
We then undertake a detailed assessment of four key country risks:
- financial risk – including country debt levels, credit ratings, and credit default swaps
- economic risk – including GDP growth, inflation, budget deficit/surplus, current account position
- political risk – including political system and government stability, internal and/or external conflicts
- ESG risk – including ESG risks not considered in other risk assessments, as well as incorporating external research
After a country review is completed, each country is given a final grade using a traffic light system of green, yellow or red:
- Green: the country is a relatively attractive investment destination
- Yellow: the country is still an acceptable investment destination, but the risk is higher than in green countries. This could be a country that is improving from a red position, but is not yet low risk. Or it could be a country where we believe the risk has increased and is worth monitoring, such as Hong Kong or Italy post the 2018 elections
- Red: the country is an unacceptable investment destination.
While every country is assessed on the four key risks identified above, the ultimate grade does not necessarily represent an equal attribution to each risk but is likely dictated by the weakest link. For example, Russia has been graded red sine 2015 despite a quite solid financial and economic position, due to ongoing political sanctions in Crimea, concerns around governance practices, and more recently the invasion of Ukraine.
The colour designation also dictates portfolio holding limits for each country – for instance, stocks from yellow countries in aggregate can only make up 25% of our global portfolio, while no stocks from red countries can be held.
The final country grade also drives the market risk premium we employ to value stocks from that country, which means the country risk is directly reflected in stock valuations.
Finally, the detailed country research helps build a strategic outlook, identifying relative country strengths and weaknesses, aiding stock coverage, and portfolio level sector and demographic exposure.
As truly global investors, we believe understanding not just a company’s drivers and risks, but also a country’s drivers and risks, is crucial to investment decisions. How can we invest in a company if we aren’t comfortable with its country of origin or operation?
This article is intended to provide general information only and does not take into account your individual objectives, financial situation or needs. Past performance is not necessarily indicative of future performance. You should seek independent financial and tax advice before making any decision based on this information.