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In the wake of COVID-19, uncertainty has risen globally, and
businesses and individuals are trying to figure out how different
the future will look.
One key question is how risks to the profitability of operations
and new investments will change globally, and how this will
differentiate between countries and sectors. The depth of the
recession will have a dramatic effect on prospective business
income. However, companies also have to assess the likelihood of
even these expected returns not being obtained. A key metric in
making these calculations is the country risk premium (CRP).
In March 2020, IHS Markit released an interim update to our CRP
calculations, with an update to our Country Risk Investment Model.
This represents the first update of country risk premium measures
since the COVID-19 pandemic spread outside of Asia, and so now is
an apt time to evaluate the difference between our approach and a
market-led approach, and in doing so understand the additional cost
due to country risk that is likely to follow this pandemic.
We find that a "bottom-up" approach, as employed by the Country
Risk Investment Model, is less volatile and more nuanced than a
markets-led approach, and result in the potential for investment
opportunities going forward, alongside the inevitable risks brought
by recession.
Country Risk Investment Model versus Market-led
Approach
The difference of approach is important to note to understand
the comparison below.
Our Country Risk Investment Model uses a "bottom-up" methodology
to estimate the CRP, assessing the potential impact on investment
returns of risks in the following areas: political, economic,
legal, tax, operational, security.
By comparison, a market-led approach uses credit spreads and
ratings as the basis for their results. This therefore takes into
the possibility of default, but also volatility of the market.
One further important difference between our method and a
market-led method is that our method distinguishes between sectors,
while the Stern method produces a single CRP for a country.
The results
A "bottom-up" approach to calculating a country risk premium
shows less volatility in the cost of country risk following
COVID-19 but does highlight some key risks that will drive
increases globally: notably recession risk and strikes and
protests. A markets-led approach shows far more volatility as the
market prices in COVID19 but doesn't allow us to dig into the
drivers of this risk or distinguish between which sectors will see
the biggest impact on country risk costs. It conversely assumes
that a Triple-A credit rating means no additional cost due to
country risk, despite the higher risk of disruption to business at
global and national level.
In our view, using CRPs derived from current market data risks
killing potentially sound investments through double counting. On
the one hand, the recession will cause volatility and uncertainty
that will deflate cash flow forecasts for future business due to
the crisis; on the other, that same volatility will negatively
impact credit ratings, which when applied to discount rates further
reduces the valuation of those cash flows.
However, this doesn't consider the fundamentals of the operating
environment, which in many cases remain robust. By relying on more
direct measures of country risk, investments can be considered in
the context of the post-COVID-19 reality without overstating the
impact of economic recession, leading to sounder decision-making
and potential opportunities for investment.
