Diversifying as a Hedge Against Political Risk

Author: Craig Featherby

Political risk and financial risk are two sides of the same coin, both of which can creep up on all of us at any time. Sometimes we are caught off-guard, and sometimes we simply fail to read the signs timeously or correctly. Often those we entrust with our destiny are unable or unwilling to correct, or even to control, such generally disastrous events, if they are not the cause of the crisis in the first place. The consequences can be both harsh and devastating.

A good case in point is the current crisis in Greece where, inter alia, banks have closed to avoid a crash, the populace is desperate to withdraw their cash and pensioners are allowed only limited pension withdrawals determined by a faltering left-wing government. Life-long savings and investments stand to be wiped out. The country has been kept going only through emergency bailouts from the European Central Bank and the International Monetary Fund, which may be running dry.

142943510_82Worse still, a full meltdown in Greece after the ‘Oxi’ vote in the 5 July referendum could threaten the future of the euro, and even the European Union (EU), with massive potential knock-on effects for the rest of the world.

Stock markets everywhere have reacted strongly, and already the euro has lost significant ground, while European stocks are
going down. The Wall Street Journal has warned in an article that a financial crisis in Europe could precipitate a collapse in investor risk appetite, which, in turn, would disrupt capital flows to emerging markets. Countries such as Malaysia, Hungary, Turkey and South Africa look particularly exposed.

Poor political decisions have resulted in the financial nightmare currently besetting half the globe.

Closer to home, in South Africa, a number of leading independent commentators have recently been warning that our country is itself on a slippery slope to disaster. The governing ANC has been accused of having its head in the sand as it continues to preach “a good story to tell” that few others apparently believe.

I am by no means an advocate of doom and gloom scenarios. This is underscored by the fact that I and the company that I head saare firmly based and rooted here, with no plans to go anywhere else. The positives of living, working and investing in South Africa are well known. This country remains filled with potential and the resources to succeed. Often the prophecies of collapse and doom are exaggerated, as we saw with some of the predictions made at the onset of the global financial crisis in 2007/08.

Yet we cannot and should not ignore the signs. We need to act proactively and plan ahead lest we end up like Greece. For investors, fund managers and ordinary citizens, diversification becomes an imperative, both in political and financial terms. But diversify against what?

South Africa is “a bomb waiting to explode”, political economist, Moeletsi Mbeki, younger brother of the former president, recently warned. The country, he said in an (CNBC Africa) interview, has “huge amounts of tension in terms of the underperformance of its economy”. He blames high unemployment – particularly among the youth – as one of the key factors that could result in South Africa’s own ‘Arab Spring’.

And, in a speech to the South African Chamber of Commerce and Industry, Mbeki blamed South Africa’s political leadership for what he termed the “comprehensive failure” in governance being the cause of poor growth, high unemployment and difficult economic conditions for business.

The former general secretary of the Congress of SA Trade Unions (COSATU), Zwelinzima Vavi, used the same language when he recently stated that, in his view, xenophobia was symptomatic of essentially four crises in South Africa that represent a “ticking time bomb”: unemployment, poverty, inequality and corruption.

Frans Cronje, who heads the Institute of Race Relations, told the Heritage Foundation in Washington that the ANC is driven by a commitment to implementing its ideology of a National Democratic Revolution (NDR) in South Africa, and not by a commitment to the Constitution as it “offers the most direct route to a socialist and then communist society”. He urged foreign diplomats and corporate CEOs to gain an understanding of this “if they are to begin the long march to safeguarding their interests in South Africa – and if they are also to play a part in protecting the country’s future as a free and open democracy”.

In his new book How Long Will South Africa Survive? well-known author, journalist and historian RW Johnson sketches a scenario unnervingly similar to the Greek one, warning of a looming crisis in which the IMF will have to bail out the country, unless the ANC goes first.

Respected historian and former professor of Political Studies at the University of Cape Town, Hermann Giliomee, broadly supports Johnson’s views and points to his previous books that reveal a “remarkable ability to read the political pulse and survival prospects of the country”. Former President FW De Klerk has also sounded the alarm, and so have quite a number of other respected commentators.

Economist Cees Bruggemans disagrees with Johnson on a number of points, but says, despite a degree of “structural equilibrium”, the South African state “may not be a stable one, given the bigger shifts in demographic demagoguery underway, and the progressive loss of private confidence and constructive participation this invites”. This structural shift, dysfunctionality and lack of confidence “undermines everything achieved so far, with potentially far worse to come”.

All of these noted commentators cannot simply be relegated to being mere voices in the wilderness.

Numsa-DancersRecent events such as costly, protracted strikes, the Marikana tragedy, xenophobic violence and even attacks on statues and cultural symbols suggest that underlying these political demonstrations are elevated levels of popular rage and frustration. These, it seems, can be attributed to the high levels of poverty, unemployment, inequality, crime, service delivery failure, and failure by government to deliver on a number of key programmes, coupled with the impacts of rising costs, recession and global crises.

Well-founded concerns have been triggered by developments on many fronts – such as a rapid increase in popular “service delivery” protests across the country; radicalised land reform initiatives; an assault on property rights; the ANC-led governing alliance’s desire to curb the independence and powers of the judiciary; its equal desire to reign in the free media; well-documented cases of corruption at high levels; a growth rate of 1.4 per cent in 2014 with few prospects for improvement; worsening labour relations; the Eskom electricity crisis; an emerging water crisis; South Africa’s growing external debt, and more.

Unless we all heed the ominous signs and pull together through a broadly inclusive social pact for ‘getting it right’, it would seem South Africa could, at any time, easily breach any one of a number of potential tipping points.

These are not simply isolated or haphazard flare-ups, and should be viewed in the context of being part of a much wider, systemic build-up of pressures that create the conditions for specific events or emergent phenomena.

Columbia University political science professor Andrew J. Nathan defines a ‘tipping point’ as follows:

“Regime transitions belong to that paradoxical class of events which are inevitable but not predictable. Other examples are bank runs, currency inflations, strikes, migrations, riots, and revolutions. In retrospect, such events are explainable, even overdetermined. In prospect, however, their timing and character are impossible to anticipate. Such events seem to come closer and closer but do not occur, even when all the conditions are ripe—until suddenly they do.”

Greece may well have reached its tipping point, and yet it was eight or more years in the making.

How then do we diversify to avoid the negative effects of crashing over a tipping point?

At the political level our options appear to be limited to exercising our democratic vote once every five years. Thus far this does not seem to augur a solution to our problems any time soon. We can, and should, however, participate in public forums. Past public submissions to Parliamentary hearings have had limited success, but pressure or involvement by civil society in processes such as, for instance, e-tolling and Eskom’s bid to persuade the National Energy Regulator of SA to increase electricity tariffs, have met with considerable success. A solid and widely supported social pact could go a long way.

In the meantime diversification, both in respect of political and financial risk, offers the best option.

A narrow definition of diversification is that it attempts to maximise return in different areas that would each react differently to the same event. A broader definition would be that diversification reduces risk by allocating investments across various financial instruments, industries, sectors, geographical regions and political jurisdictions. In everyday jargon diversification is simply ‘hedging your bets against different possible outcomes’.

On the financial and investment front the options to diversify are much more substantial, and easier, especially in view of the ongoing trend towards greater globalisation. You certainly don’t need to have all your eggs in one risky basket.

It may be argued that the JSE has performed well and that domestic financial markets have provided investors with good returns for many years. But offshore investing has become more attractive for South Africans, especially given the risk factors outlined above. The Franklin Templeton Global Investor Sentiment Survey 2014 found that 85 percent of South Africans now believe better investment options reside offshore. While the JSE is still performing well, it is being overshadowed by stronger performance in other markets.

Although diversification can never fully rule out loss, investment professionals commonly seem to agree that it is the most important component of achieving one’s long-term financial goals while minimising risk.

Good reasons for diversifying your investment in offshore markets include the wider choice of asset classes and sectors to select from; better tax regimes; a better regulatory environment, and other benefits; spreading your investment beyond South Africa’s relatively small domestic market, and more attractive growth and value options. And diversifyin will also secure better insurance against domestic political and economic upheaval, at the very least for a portion of your investment portfolio.

And with advances in globalisation and the removal of many former barriers, it has become much easier. There are many highly professional and regulated independent financial advisers who can advise you regarding the many financial and investment instruments available in this regard.

With several recent crises affecting many parts of the world, you may wonder where there is a truly safe place to invest. There are never any watertight guarantees. But, for instance, a jurisdiction such as Gibraltar is a highly attractive destination. It has demonstrated its ability to remain immune to past upheavals on the European continent. It is well-governed and stable, and while largely independent, nonetheless enjoys ‘protection’ from its parent, the United Kingdom, whose economy is also on a stronger trajectory these days. Furthermore, it has a strong and well-regulated financial services and investment industry, together with a range of tax and other benefits. There are numerous other offshore options that are similarly attractive.

So, until South Africa can solve its many political challenges and thus also secure its economic future, diversifying through offshore investment would seem the wise and obvious choice.

Craig Featherby is Group Managing Director of financial management company Carrick Wealth in Cape Town. He writes in his personal capacity.

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