Asset Allocation: Global Asset Management : Risks

The 'safety' of asset markets can be threatened by both socio-political (sovereign and country) risks and inflation (erosion of purchasing power).

Sovereign and country risk

Sovereign risk relates to the reliability and stability of a country's political and legal establishment. At its most extreme, it involves the danger of expropriation of assets (financial and physical) by a government, or a government imposing foreign exchange controls to prevent an exodus of capital.

Country risk is about the integrity of a nation’s institutions. Financial assets need a strong basis in contract law to prevent an issuing party from not honouring its obligations, and to protect the investor against any third party interference. The reliability of a country’s accounting and banking practises is also an element of country risk.

A slightly more indirect threat to asset values is the risk of socio-political unrest, which, if it does not threaten the investor’s ownership of assets, will increase counterparty credit and investment risk by endangering the smooth-running of the economic system.

Inflation risk

Inflation is highly damaging to both equity and bond market returns; as a quick comparison between the real and nominal returns on three asset classes in the US since 1945 makes clear.

Solution

A safety-first philosophy puts assets into the strongest, ‘hard’ currencies. A hard currency is one which has exhibited a long-term uptrend. This happens when a Central Bank succeeds in pursuing anti-inflation policies over the long-term, bringing inflation rates below that of competitor countries and exhibiting low, stable interest rates.

The Swiss franc has always been the classic ‘safe haven’ currency - with a stable political and economic system, and full confidence in the strength of legal contracts to protect the investor. You know where you are with the Swiss franc. The Deustchmark was, historically, a second-choice home, with a fine economic (anti-inflation) record and stable political system. The eurozone is, as yet, too undeveloped both economically and politically to provide these features.

The US dollar is not a ‘hard’ currency in the strict sense of preserving its purchasing power. Although successful across the 1990s in treading the line between inflation and deflation, the USD has exhibited long-term downtrends reflecting erratic anti-inflation policies. (The same is true of Pound Sterling - GBP). And because its society is so dynamic it is not a ‘stable’ economic zone. It is creative, chaotic and so sometimes destructive. USD denominated assets exhibit significant asset price volatility - and this is exacerbated by the fact that huge amounts of the world’s riskiest assets are priced in USD (e.g. emerging market debt, junk bonds etc...) - as are the world’s physical commodities (hard and soft commodities, precious metals, fossil fuels etc...).

In times of global confidence, there is strong demand for USD so the dollar appreciates against its competitor currencies; but in times of global anxiety, there is usually a noticable USD depreciation.

The USD is the most significant global investment currency not because it is ‘hard’ in anti-inflation/purchasing power terms - but because its strong legal system and dynamic economy have produced the greatest variety, depth and sophistication of investment opportunities available anywhere in the world.