Why country risk matters

Sarah Shaw

4D Infrastructure

Right from the early origins of the 4D business, country risk was a key area that we thought needed to play a significant role in our investment process. 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?

In this article, we describe how the assessment of this key variable evolved to what it is today. First, however, we want to briefly demonstrate why country risk has always been so important to us.

Country risk is real

Country risk is real, and shifts over time both in a positive and negative direction.

The current Russia/Ukraine war demonstrates country risk. Russia has been severely sanctioned by the international community as a result of its actions. At 4D, we have always graded Russia as red.

There has been no greater event exposing country risk than that exhibited during the global financial crisis (GFC) from 2007-2008. 

Prior to the recent COVID-19 recession, the GFC was considered the most serious financial crisis since the Great Depression (1929-1939). So, using changes in a country’s long-term Standard and Poor’s (S&P) credit rating as a proxy for changes in country risk, how did major global economies fare during the GFC and since?

Some nations really struggled, but 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’ (see chart 1 below). Now that is country risk deteriorating rapidly! Fortunately, Greece has exhibited a gradual recovery since then, although 4D still rates it as a red jurisdiction as a number of key metrics remain stretched and it has a propensity to quickly move into political instability. 

Source: World Government Bonds

But it is not just major, high-profile, macro events 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, chart 2 reflects 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 of Japan. Similarly, but more quickly, the UK rating deterioration shown below reflects its decision to exit the EU, which was driven by a narrow June 2016 referendum result (52% voted to leave, 48% to remain).

At 4D we currently grade both Japan and the UK as green jurisdictions, although the UK experienced some time at yellow during Brexit.

Source: World Government Bonds

Importantly, changes in country risk can also be positive. China’s rating history (see chart 3 below) very clearly reflects its economic and social growth and advance during the 21st century, with a steady rating climb since the early 1990s. We grade China as green.

Source: World Government Bonds

Finally, some things just ‘seem right’ and don’t seem to change, as reflected by Germany’s rock solid ‘AAA’ rating history below, and the ‘almost’ rock solid history of the US. We rank both countries as green.

Source: World Government Bonds

4D’s approach to country risk assessment

Our approach to country risk assessment is designed to answer one key question: is the country under review an acceptable investment destination?

To get the process underway, and provide a perspective on a country during its initial review, countries are given a Preliminary Grade based on their S&P long-term credit rating as follows.

This is a preliminary rating only. We then complete the 4D country review process, which involves a detailed assessment of the four key country risks below.

After a country review is completed, each country is given a final grade using a traffic light system of:

  • 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. 

That is, the ultimate grade (if not green) is likely dictated by the weakest link. For example, Russia has been graded red since 2015 despite a quite solid financial and economic position, due to ongoing political sanctions in Crimea, concerns around governance practices, and the recent Russian invasion of Ukraine.

This final colour designation dictates how much of the global fund’s investment portfolio, in aggregate, can be allocated to stocks in that particular country grade. For example, as shown in table 7 below, stocks from yellow countries in aggregate can only make up 25% of the global portfolio. No stocks from red countries can be held in the portfolio. These gradings are assessed at both a listing and asset level.

The final country colour grading also dictates the market risk premium (MRP) we employ to value stocks from that country – the lower the country grade, the higher the MRP used, 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 as well as portfolio level sector and demographic exposure.

A fully integrated investment process at 4D

Because our country reviews have a direct link to company financial models (via the MRP) and lead to hard portfolio country limits, we believe our investment process is fully integrated, with country risk assessment playing just as important a role as our stock reviews and valuations. We believe this is unique to 4D.

A selection of 4D’s country risk assessment outcomes

We have been employing our country review process since 4D’s inception in 2015. Each relevant country is assessed at least annually, but an interim review can also be triggered by a particular event such as Brexit. 

In 2021, we completed over 30 country reviews, with 70% ranked green, 15% yellow and 15 % red. Some of the interesting rankings and changes over the past six years are summarised below.

Conclusion

At 4D, we have always considered country risk a key factor in stock analysis and portfolio construction. The GFC provided a very real demonstration of country risk in practice. In response to that, we intentionally developed an integrated investment process that included both country and stock analysis as described above. We believe our investment process is both effective and unique, and has supported our overall performance since inception.

Invest across the globe

4D Infrastructure, a Bennelong Funds Management boutique, invests in listed infrastructure companies across all four corners of the globe. For more insights on global infrastructure, visit 4D’s website


Managed Fund
4D Global Infrastructure
Alternative Assets
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1. The source for this data only reports the US S&P rating from April 2011, accounting for the short duration of this chart. The content contained in this article represents the opinions of the author/s. The author/s may hold either long or short positions in securities of various companies discussed in the article. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the author/s to express their personal views on investing and for the entertainment of the reader. This information is issued by Bennelong Funds Management Ltd (ABN 39 111 214 085, AFSL 296806) (BFML) in relation to the 4D Global Infrastructure Fund and 4D Emerging Markets Infrastructure Fund. The Funds are managed by 4D Infrastructure, a Bennelong boutique. This is general information only, and does not constitute financial, tax or legal advice or an offer or solicitation to subscribe for units in any fund of which BFML is the Trustee or Responsible Entity (Bennelong Fund). This information has been prepared without taking account of your objectives, financial situation or needs. Before acting on the information or deciding whether to acquire or hold a product, you should consider the appropriateness of the information based on your own objectives, financial situation or needs or consult a professional adviser. You should also consider the relevant Information Memorandum (IM) and or Product Disclosure Statement (PDS) which is available on the BFML website, bennelongfunds.com, or by phoning 1800 895 388 (AU) or 0800 442 304 (NZ). Information about the Target Market Determinations (TMDs) for the Bennelong Funds is available on the BFML website. BFML may receive management and or performance fees from the Bennelong Funds, details of which are also set out in the current IM and or PDS. BFML and the Bennelong Funds, their affiliates and associates accept no liability for any inaccurate, incomplete or omitted information of any kind or any losses caused by using this information. All investments carry risks. There can be no assurance that any Bennelong Fund will achieve its targeted rate of return and no guarantee against loss resulting from an investment in any Bennelong Fund. Past fund performance is not indicative of future performance. Information is current as at the date of this document. 4D Infrastructure Pty Ltd (ABN 26 604 979 259) is a Corporate Authorised Representative of BFML. Livewire gives readers access to information and educational content provided by financial services professionals and companies (”Livewire Contributors”). Livewire does not operate under an Australian financial services licence and relies on the exemption available under section 911A(2)(eb) of the Corporations Act 2001 (Cth) in respect of any advice given. Any advice on this site is general in nature and does not take into consideration your objectives, financial situation or needs. Before making a decision please consider these and any relevant Product Disclosure Statement. Livewire has commercial relationships with some Livewire Contributors.

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Sarah Shaw
Global Portfolio Manager and Chief Investment Officer
4D Infrastructure

Sarah has almost 30 years of experience across financial services, including 20 years focused on global listed infrastructure. She is an experienced portfolio manager, having successfully launched and managed several listed infrastructure funds...

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