How to deal with geopolitical risk

How to deal with geopolitical risk

Investor insights 19 & 20 APRIL 2013, OKURA HOTEL AMSTERDAM

>6 China: boom or bust?

Two opposing views from Walker and Mahbubani

>8 Middle East protestors are capitalists just like us -says economist de Soto

Senkaku Islands dispute (Japan/China)

Recession ahead for China?

Eurozone debt crisis

Continuous turmoil in the Arab world

What is geopolitical risk?

Geopolitical or political risk is the risk that an investment’s returns could suffer as a result of political changes or instability in a region. Instability affecting investment returns could stem from a change in government, legislative bodies, foreign policy makers, or military control.

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Political risks are notoriously hard to quantify because there are limited sample sizes or case studies when discussing an individual nation. The outcome of a political risk could drag down investment returns or even go so far as to remove the ability to withdraw capital from an investment (source: Investopedia).

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In the current market environment, geopolitical risk is not limited to emerging markets, but has an influence on the developed markets as well.

The crisis in the euro-zone is a case in point. This risk affects all asset classes, including sovereign bonds.

CONTENTS 4 In brief Two contrasting views on 2013’s biggest geopolitical risk: emerging markets vs global weirding

5 We have a gigantic bubble. Investors need to diversify Q&A with Marc Faber

6 What are the prospects for China?

Bullish Kishore Mahbubani goes head to head with bearish Jim Walker

8 Middle East protestors are capitalists just like us Hernando de Soto on why property rights for the informal economy are essential for building a successful market economy

9 Investors should expand their bond universe Corestone’s Martin Mlynár makes the case for active management

10 The philosophy of evidence-based investing Robeco quant researcher Joop Huij argues that investors should look to developments in medicine for inspiration

1 Asset allocation has become more difficult 1 than ever Q&A with Towers Watson’s Roger Urwin

12 Heard at the Robeco World Investment Forum

TODD BENJAMIN Moderator “My main take away of the Investment Forum is that social inequality can trigger geopolitical turmoil in the future. De Soto made clear that social inequality has been a major driver of the revolutionary wave in the Arab world, also known as the Arab Spring. He examined the reasons why protestors set themselves on fire. All 64 of the self-immolation protesters were entrepreneurs.

They made their dramatic statements to protest against the expropriation of their businesses.”

INTRODUCTION Each year we aim to discuss topics that matter to investors at the Robeco World Investment Forum. This year’s theme, “Geopolitical risk & capital markets”, provided plenty to talk about, since much of what happens in the world potentially affects the capital markets. From the euro-zone debt crisis to the flashpoints in Iran, the East China Sea or the 38th parallel the risks involved have implications for your portfolio. Our goal was to bring together visionary thinkers and give them the opportunity to challenge other points of view.

The Forum was held at the Okura hotel in Amsterdam – a well-chosen venue, given our new strategic shareholder, ORIX Corporation from Japan. The new ownership is exciting in that Robeco and ORIX are both customer-oriented, entrepreneurial and rely on the talents of their employees; a good fit! In addition, ORIX wants us to keep doing what we do best: focus on realizing attractive investment returns for you.

We may live in a volatile world with many pitfalls, yet I am optimistic by nature. As Martin Mlynár said, rather than avoid risk at all costs, think in terms of risks and rewards, and build a diversified portfolio, resilient to events.

The Forum delivered a surprising insight: social inequality emerged as the principal geopolitical risk. This opinion was shared by most of the audience. I was further impressed by many excellent speakers who provided invaluable information for investors. The lively exchange between Jim Walker and Kishore Mahbubani about China was particularly memorable, and our own experts Joop Huij and Martin Mlynár underpinned Robeco’s active involvement in the debate.

We have compiled a series of articles for this publication that capture the viewpoints of this year’s speakers. I do hope you will find this update useful!

RODERICK MUNSTERS, CEO ROBECO

Todd Benjamin moderated the Robeco World Investment Forum.

He was an anchor, correspondent and financial editor for CNN and has interviewed makers of history, from Mikhail Gorbachev to Alan Greenspan.

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IN BRIEF

Why emerging markets are 2013’s biggest risk Emerging markets not only have structurally higher growth than their developed counterparts but by many measures they also have more-solid fundamentals, thanks to the absence of the massive government debt problems and the fiscal deficits that plague most developed markets. Right?

Wrong, says Willis Sparks, New York-based Global Macro Director with Eurasia Group. In fact, the political risk research and consulting firm rates emerging markets as the number-one geopolitical risk for 2013.

“Political risk never left emerging markets,” observes Sparks. “The focus on Europe and the US has obscured the fact that emerging markets countries are structurally less predictable than developed markets. That hasn’t changed. Investors just forgot about it.”

Eurasia Group’s thesis is that while some emerging markets continue to offer decent opportunities, it is crucial to understand that “the era of emerging market abundance is finished”. And that the downside in emerging markets varies dramatically from country to country. In some instances, notes Sparks, that risk can be “unbounded”.

Top geopolitical risk for 2013 Robeco Chief Economist Léon Cornelissen on what will keep world leaders busy this year.

It isn’t cyber attacks, the eurozone debt crisis or the flashpoints in Iran, Korea or the East China Sea. So what is the geopolitical issue most likely to boil up in 2013?

Cornelissen is most concerned about the immediate impact of global weirding. That’s because extreme weather that destroys crops widely can feed through into higher food prices rapidly, causing social unrest.

“Don’t forget that the Arab Spring was ignited by exploding food and agricultural prices,” he says.

To read the five top political risks go to: https://www.robeco.com/blog

To read the full analysis go to: https://www.robeco.com/blog

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the Asian middle class by 2020, up from the current 500 million, forecasts Kishore Mahbubani

“We have a gigantic bubble.

Investors need to diversify” Another crisis is inevitable, contrarian investor Marc Faber argued at the Robeco World Investment Forum. So how should investors position themselves? And how can you spot when the asset-price bubble will burst?

Q: Do you believe that current asset prices accurately reflect the risks?

A: No, certainly not. Asset prices today have been distorted by artificially low interest rates.

If interest rates are at zero, it is difficult to value anything. There is no real value.

Q: What is the way out from the current situation?

A: The way out is to do something different from what we have done in the past. Under the influence of today’s central bankers and neoKeynesian politicians, there is more stimulation, more government intervention and more money printing. They do precisely the things that led to the crisis. That is not the right medicine.

economy. But before that, most likely we will have high inflation, maybe a deflationary collapse and wars. We are all doomed.

Q: What should investors do?

A: We have to live with the fact that money is being printed. This money will flow into different sectors and different markets. This will lead to more volatility. Investors need to diversify and avoid buying assets that have become overly popular.

Q: Which indicators can predict when the bubble will burst?

A: One indicator is already flashing a very heavy warning signal. Asset prices are rising, but the standards of living of the typical household in Europe and the US are falling.

The linkage between money printing and the industrial economy has broken down.

The rich are buying completely unproductive assets. Nothing is being created economically.

Q: We are still in the monetary easing phase.

What is going to happen?

A: We will have a huge systemic crisis. The next phase is for governments to go bust. We do not know when the crisis will happen. It could happen tomorrow, but it could also happen in three, five or ten years’ time. Like when your computer crashes, there will be a re-booting of the global

Q: Do you predict a revolution if income inequality increases further?

A: When the poor become more powerful than the few, the rich have to pay. Usually history has solved this problem by redistribution through taxation or by revolution. The bailout of Cyprus is the beginning: the rich have to pay more than the poor. The writing is on the wall.

> Click here to watch Marc Faber at the Robeco World Investment Forum

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What are the prospects for China? Bullish Kishore Mahbubani (right) goes head to head with bearish Jim Walker 6

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Discussion

China’s short-term prospects are bleak, with a recession ahead, argued Jim Walker. But its longer-term rise, along with the wider Asian region, is unstoppable, countered Kishore Mahbubani.

China’s economy is faltering. First-quarter GDP growth disappointed, with a 7.7% year-on-year increase. The government is warning that the country has entered an era of lower growth, as it rebalances the economy towards domestic consumption. What are the implications of this shift, both in the short term and the long term?

For Jim Walker, managing director at Asia­ nomics, the independent economic research company, China is at a critical juncture.

And the outlook is not good. “We think there’s a recession ahead for China,” he said.

“Not just lower growth, but a recession.”

‘Rising geopolitical competition between China and the US is inevitable‘ Kishore Mahbubani.

China saved the world but killed itself Why? “China killed itself when it saved the world in 2009,” said Walker. That is because of the extraordinary credit expansion since the start of the financial crisis. In 2009, the Chinese injected new credit into the economy equivalent to 43% of Chinese GDP. And they have injected similar amounts every year since. Moreover, this credit expansion actually accelerated in the first quarter of this year.

The inevitable result of these floods of money is overcapacity across the economy. “When countries have overcapacity, they don’t make money in their corporate sector,” said Walker.

And that is the case in China, he said, as the earnings reported by companies there

‘We think there is a recession ahead for China‘ Jim Walker.

“don’t actually exist”, thanks to accounting sleights of hand. “Companies have got to cut capital expenditure. And banks have got to stop lending to them,” he said. “When that happens, you get recession.”

Still, Walker’s picture of China isn’t 100% gloom. “The Chinese take such crises on the chin,” he commented in his interview.

“Recession in China will come as a surprise”, before they bounce back.

No avoiding Sino/US geopolitical competition Still, Mahbubani accepts there are risks for China, both internally and externally. Abroad, there are geopolitical tensions within the Asian region and with the US, whose numberone position in the global economy China is challenging. “Rising geopolitical competition between China and the US is inevitable,” said Mahbubani.

Mahbubani: a major historical aberration is ending According to Kishore Mahbubani, Professor in Public Policy at the National University of Singapore, China’s bounce-back is long overdue. Mahbubani’s stock in trade is not so much the rise of Asia but its return.

He argues that until 1820, the world’s two largest economies were China and India. And after two centuries of Western domination, the world is returning to the historical norm of the previous two millennia. In this longerterm perspective, the supremacy of Britain and the US should be viewed as “a major historical aberration”. “All aberrations come to a natural end,” he said. For Mahbubani, “the big question” about Asia’s return to the center stage of world history “is why? And why now?”

Asians have learnt best practices from the West His answer is that Asians have absorbed and understood Western best practices in many areas, from free-market economics to innovation in science and technology.

They have also instilled in many cases a belief in meritocracy and the rule of law, and developed what he referred to as a “culture of pragmatism”.

But he believes the Chinese government is too pragmatic to allow such tensions to have a long-term impact on economic relations.

“There will be geopolitical rivalries. There will be no geopolitical wars,” he argued.

Will China become the world’s #1 economy?

So where does that leave China’s progress to economic top dog? For Mahbubani, it is just a matter of time—and not that much time either. He said that by 2017, China’s share of global GDP will have risen to 18.2% in purchasing power parity (PPP) terms, when the US’s share will have dropped to 17.6%.

Walker was more skeptical. “China will become the biggest economy in the world as long as it keep publishing numbers that don’t mean anything,” he noted.

> Click here to watch Kishore Mahbubani at the Robeco World Investment Forum > Click here to watch Jim Walker at the Robeco World Investment Forum

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DIFFERENT PERSPECTIVE

Protestors in the Middle East are capitalists just like us Property rights for the informal economy are essential for building a successful market economy. But their absence, which is creating turmoil in the Middle East, is a serious geopolitical risk, warns economist Hernando de Soto.

For Hernando de Soto, the biggest geopolitical fault line is the people who are not part of the developed economy. “Of seven billion people in the world, only two billion people can connect with each other. The rest of the people are out”, said the chairman of the Institute for Liberty and Democracy in Peru.

Mohamed Bouazizi Mohamed Bouazizi (1984-2011) was a Tunisian fruit vendor who set himself on fire after his goods were confiscated. His death started protests and was the spark of the Arab Spring.

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Who are these five billion? They live in developing countries and are part of the informal economy. An informal economy has no property rights. It is an area where the rule of law does not exist. But capitalism only works well, said de Soto, on the basis of property rights and the rule of law. It is a system where economic information about assets and people is stored on paper. And the consequences of not having good paper, he stressed, are enormous.

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Property rights are a necessary part of capitalism everywhere The drawbacks of informal businesses are numerous. “They normally have one owner; they do not have personnel, sometimes only a few family members work in the business,” said de Soto.

That’s not all. “They cannot issue shares or get loans in order to expand. They cannot offer collateral and have unlimited liability. They do not have protection against the acts of government officials,” he added.

Nor can informal businesses expand. “In order for businesses to expand, you need ownership documents,” he noted. “Once you have these documents, they can be used for a loan or for a guarantee.”

Arab Spring started out of a desire for property rights De Soto pointed to the Middle East as one area of the world where the lack of property rights and the rule of law are creating turmoil. In fact, he said, the Arab Spring was kick-started by a

Investors should increase their bond universe The financial crisis has caused a ‘regime change’ in the bond market. How can investors deal with this change? Martin Mlynár, head of the institutional asset manager Corestone, has some advice.

First, the passive strategy of following a benchmark with triple-A-rated bonds will no longer do, says Mlynár. “Because the pool of these assets is shrinking.” He urges investors to become more active. “Active management is needed, because passively following a benchmark is no longer sufficient to achieve the long term goals”, he says.

Second, investors should look differently at emerging markets. “They are no longer a periphery within the bond market and investors should include them in their portfolios.”

Mlynár also offers advice on how to enter these markets. ”You need to focus on good credit quality, take liquidity into account and allow for hard and local currencies.”

desire for property rights and the rule of law. Indeed, the catalyst that prompted the Arab Spring was the self-immolation of a Tunisian fruit vendor called Mohamed Bouazizi on 17 December 2010. He set himself on fire because his goods had been confiscated.

High quality sovereign bonds have seen increasing demand during the financial crisis, because investors prefer safety in uncertain times. Yet supply of such bonds has been shrinking – due to a wave of downgrades during the financial crisis – and will likely continue to shrink. “100% guarantee has now become very expensive. Rather than seeking to avoid risk at all costs, we should look at risk in combination with reward.” > C lick here to watch Martin Mlynár at the Robeco World Investment Forum

‘Capitalism does not need to be re-thought or re-invented; it simply has to be re-discovered.’

But Bouazizi’s action was not an isolated event.

Around the same period in the Arab world, 64 people set themselves on fire. De Soto said they were all small entrepreneurs and had similar motives: their businesses had been destroyed by government officials.

The Institute for Liberty and Democracy interviewed survivors and asked them why they had resorted to setting themselves on fire. None made political or religious

statements. Instead, they were furious that corrupt local government officials had expropriated their businesses. The Arab Spring was a revolution that was started by small entrepreneurs, he concluded.

A challenge for the West The challenge for the West is to harness that force by helping to set up legal protection, de Soto advised. This provides an opportunity.

It can help in building successful market economies and stopping instability in the region.

But he also issued a warning. The West must not make the mistake of seeing protestors

in the Middle East as religious extremists or terrorists. “These guys are capitalists just like us, even though they don’t wear striped suits.”

‘The Arab Spring was a revolution that was started by small entrepreneurs.’

> Click here to watch Hernando de Soto at the Robeco World Investment Forum

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The case for evidence-based investing

You wouldn’t be happy if your doctor proposed bloodletting to cure an illness. Yet many investors are happy to put their trust in theories that have no more credence than this discredited practice. Robeco researcher Joop Huij believes that investors should follow the example of modern medicine and adopt an evidence-based approach.

For 2,000 years, doctors practiced blood­ letting—extracting small quantities of blood—to treat a variety of complaints, even though there was no evidence that it was an effective cure. Of course, bloodletting is no longer in widespread use. That’s because of the rise of evidence-based medicine: decisions based on statistics to assess if therapies are effective. Joop Huij argued that the financial world should learn from medicine. All too often, investors base their decisions on conventional wisdom that is not supported by evidence showing that it works. Consider two issues at the heart of investing. Is there value added of active investment management? And can some active managers systematically outperform passive benchmark indexes? According to conventional wisdom, in the form of the

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so-called Yale model, the investment approach devised by Yale CIO David Swensen, the answers to those questions are “no” and “no”.

Yale model links outperformance to market inefficiency The “Yale” arguments run like this. Active management has no incremental value in developed markets. Investors are better off buying low-cost index funds there. That’s because developed markets are efficient and there is strong competition between asset managers. Active management thus has more value in inefficient market segments, such as small caps or emerging markets. Active risk budget is best spent in inefficient segments.

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Yale model not supported by evidence That’s the theory. But is it supported by empirical evidence? In fact, research by Huij shows that the value of active management is not correlated to market efficiency.

‘There is no empirical evidence supporting the Yale model’ It turns out that outperformance is a result of market breadth, or the range of independent investment opportunities in a market. “There is no empirical evidence supporting the Yale model”, concluded Huij. > Click here to watch Joop Huij at the Robeco World Investment Forum

‘Asset allocation’ has become more difficult than ever Financial markets are under the spell of politics. That is why asset allocation has become more difficult than ever, says Roger Urwin, Global Head of Investment Content at the consultant Towers Watson. What does that mean for your portfolio?

What major changes have you seen in the investment landscape in the last few years?

It is much more complex because the range of choices has expanded a great deal. Ten years ago, the big pension funds considered six or seven asset classes. Today, you might find 15 different allocations. People are thinking about their portfolio much more through additional risk factors. This has had the benefit that they understand the risks better than they did in the past.

What are the prospects for returns for the next couple of years?

CPI inflation plus two or three percent seems to be a realistic expectation for a portfolio that has a 60/40 equity/bond split. But that doesn’t satisfy most people’s objectives. They need more than that. Their search for additional return has often been in the alpha space: managers being able to outperform existing benchmarks. But the more interesting development is how people are pursuing many more opportunities in a variety of diversified betas. In particular, people are emphasizing smart betas in their portfolios.

How best to deal with geopolitical risk?

Geopolitical risk permeates the whole landscape of opportunities. Markets are very keyed into growth, so shocks to growth are one of the things that portfolios have to be very sensitive to. Dealing with geopolitical risk is basically having a more accurate view of the future than other people and positioning portfolios to deal with expected risks in a sensitive way.

What’s different is that politics are affecting economies and markets more. They are several times more important than they were prior to 2008. We’ve been through a period in which politics has almost been the biggest thing and that has created a very unmanageable type of situation. That’s why asset allocation has become more difficult than ever. Now, we may learn to live with that and re-adjust the mix of factors, making sure that we’re not so surprised by policy issues.

it is feeling less good about the potential for economic growth, particularly in developed economies on a five- or ten-year horizon.

It is very difficult to hedge that risk.

‘Geopolitical risk permeates the whole landscape of opportunities.‘

Why are politics more important than they used to be?

The linkage to the real economy. Policy issues are having much more impact on shocks to growth than they did five years ago. So the market swings about because suddenly

> Click here to watch Roger Urwin at the Robeco World Investment Forum

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Heard at the Robeco World Investment Forum Jim Walker: “Abenomics is the economics of the madhouse.”

Roderick Munsters: “Think about making investment returns resilient.

You need to run risk, but you need to do it in a structured way.”

Hernando de Soto: “You in Europe have got democracy. We have got elections.”

Kishore Mahbubani: “As the Islamic world becomes more successful economically and more assertive politically, then you’ll see a real challenge for the West.”

Roger Urwin: “There is nothing zero risk about what’s in a benchmark.”

Joop Huij: “When doing factor investing, people should diversify, not pick their favorite flavor.”

Martin Mlynár: “The end of ‘risk-free‘ assets will require a move from passive allocations to active management.“

Marc Faber: “I believe that asset prices today have been distorted by artificially low interest rates.”

Robeco Coolsingel 120, 3011 AG Rotterdam, The Netherlands forum@robeco.com https://www.robeco.com/blog Important Information This document is solely intended for professional investors under the Dutch Act on the Financial Supervision (Wet financieel toezicht) Robeco Institutional Asset Management B.V. ( (trade register number: 24123167) has a license of the Netherlands Authority for the Financial Markets in Amsterdam. It is intended to provide the reader with information on Robeco’s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. The information contained in this document is solely intended for professional investors under the Dutch Act on the Financial Supervision (Wet financieel toezicht) or persons who are authorized to receive such information under any other applicable laws. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation. The value of your investments may fluctuate. Past results are no guarantee of future performance. All copyrights, patents and other property in the information contained in this document are held by Robeco. The views expressed by the speakers do not necessarily represent the views of Robeco. Robeco Institutional Asset Management B.V.( (trade register number: 24123167) has a license of the Netherlands Authority for the Financial Markets in Amsterdam.

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