Hermes Thought Piece Political Risk CM108612

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www.hermesfundmanagers.com

Political RiskThe impact on investors

3 Introduction

4 Political Risk

What is it, where is it and why

does it matter for investors

7 European Equities

The new Wild West: Why politics

matters for investors in Europe

9 Commodities

Beyond borders: Whycommodities investing goes

beyond geo-politics

10 Japan

Stable boat, choppy ocean:

Political risk in Japan

11 Real Estate

London Calling: Why Londonremains a safe haven for real

estate investors

13 Global Equities

Why looking under the bonnetmatters when buying global

equities

15 Global Government andInation Bonds

In the driving seat: Howgovernments drive bond

markets

17 Hedge Fund Solutions

White noise: How to cut through

the politics and find returns

18 Emerging Markets

Hidden gems: Why political riskis an opportunity in emerging

markets

Thought PieceSeptember 2012


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Thought Piece September 2012


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www.hermesfundmanagers.com | 3

Hermes Fund Managers Limited

World Map 2012

Source: iStockphoto

IntroductionIncreased conflict within countries and between them developedand emerging alike is leading to a rise in political risks for portfolios.Knowing what and where to invest in an era of politically motivatedeconomic intervention, increased threat of sovereign defaults and

heightened political tensions is a vital aspect of investments thisdecade and beyond.

At Hermes Fund Managers we see politics as a fundamental risk weneed to analyse alongside traditional economic measures. The realityfor investors today is that politics and economics are so intertwined,neither can be assessed in isolation.

The following is a look at how Hermes is addressing the changingpolitical environment and what it means for the respective assetclasses in which we invest.

Hermes does not have a house view on assets or investmentopportunities but one area where we all agree we cannot ignore the

risks of todays political economy.

World Map 1902

Source: Getty Images

Approximately 30 independent governments US government spending as percentage of GDP c.6%

US empire on the rise

British Empire waning

More than 193 independent governments

US government spending as percentage of GDP c.40%

Chinese empire on the rise

US empire waning

Source: www.usgovernmentspending.com and Hermes Fund Managers Ltd.


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The US is a superpower that realises its grip is being threatened.Throughout history there comes a tipping point for every empire whena nation starts to spend more on servicing its debt than on its armedforces. In the US this is likely only 10-15 years away.

What happens when a massive military country starts to lose power? Iteither isolates itself, and the US has the capability to do just that, withits neighbours, Mexico and Canada, able to supply it with cheap labourand natural resources, or, it expands its territory.

Meanwhile, Europe, struggling with structural flaws and variednational interests, is fragmenting. Tension between the countries ismounting in much the way it did in the 19th century, and we all knowhow that played out.

The idea of war between developed nations in modern times mayseem absurd, yet it is not that far-fetched. Do not forget that for mostof modern history these nations have gone to war over economics.Considering todays growing wealth divide, both between countriesand within them, it is entirely possible that at some stage some willsay enough and seek forcible change.

Across western countries we are already witnessing the buddingsentiment that democratic governments are ruled by a political eliteand the wealthy which disenfranchises the majority. The upsurgeof the Tea Party movement to rival the long-standing, two-party USpolitical system (partly a reaction to the impending end of the Anglo-Saxon populations position as the majority) and the recent showing ofright-wing parties in many European nations, is demonstrative of thefact that in times of strife, political extremism grows.

Political change and influence may be slow to occur, but it is alreadybeing felt in many western markets. Just look at the politicallymotivated interference in the investing and corporate regulatoryenvironments. Many asset managers today are also attempting towork out the investment scenarios of a continuation or break-up of theEuro. However, in order to appreciate the full picture, analysts need tobetter understand the workings of Germanys ruling coalition. Whatare its concerns and motivations? The mounting US debt problem isa concern for investors, yet in order to gain a clearer picture of anysolution, analysts need an understanding of US politics.

The legacy is debt build-up

Gross & net government debt as % GDP

1997 2013p

Moodyslocal ccy Gross Net Gross Net

US Aaa (-ve) 67 49 111 88

Japan Aa3 102 34 223 143

Eurozone n/a 81 54 100 63

UK Aaa (-ve) 52 31 108 78

Greece C 101 78 173 141

Italy Baa2 (-ve) 130 104 122 96

Iceland Baa3 (-ve) 771 431 125 54

Ireland Ba1 (-ve) 631 421 127 87

Latvia Baa3 (+ve) 532 n/a 75 n/a

OECD av 74 44 109 71

11998 data22000 dataSource: OECD, Thomson Reuters Datastream, & Moodys Investor Services

Political Risk:What is it, where is it and why does it matter forinvestors?Political risk is a growing influence on investments in developed

markets and one we expect to accelerate over the coming decade.Although investors have tried to incorporate an element of geopoliticalrisk assessment in emerging markets investments, it has been atleast two generations since they looked at the issue of political risk inthe context of developed economies. They need to start.

In the history of developed markets, political risk was once the normbut faded as an investment consideration post-World War II. Sincethat time, we have witnessed a period of great stability, in part becausethe ensuing Cold War gave developed nations a common, externaladversary to worry over. With no common enemy anymore andmounting internal concerns, the idea we are all friends in the West isdwindling.

Today, growing unrest brought on by anger over austerity, worriesabout resource scarcity and threats of increased taxation, hasrefocused attention on national problems as opposed to internationalconcerns. In such an environment, politics can have as much impacton the attractiveness of different markets as GDP figures.

Europe and the US are the two largest markets where politics is sureto play an important role. We have already seen the beginning salvos,with riots in Greece, rising tension between EU member countriesand increased protectionism from the US. There are tectonic shiftsoccurring in these countries, emanating from changes in world power,the disparity of wealth, demographic shifts and the escalation ofpopulism.

The higher the Misery Index, the greater the expected economic hardship

2012p1 Unemployment ratesMisery

% point2 3

Ur

ate

CPI

2007

2008

2009

2010

2011

5yrav

2012

2013

Greece 20.0 1.4 8.3 7.7 9.5 12.6 17.3 11.1 10 9

Spain 23.5 1.5 8.3 11.4 18.0 20.1 21.7 15.9 8 6

Ireland 15.0 1.0 4.6 6.3 11.8 13.7 14.5 10.2 6 8

Portugal 14.2 3.0 8.9 8.5 10.5 12.0 12.9 10.6 4 7

Italy 10.0 2.7 6.1 6.8 7.8 8.4 8.4 7.5 3 2

France 10.0 2.4 8.4 7.8 9.5 9.8 9.7 9.0 1 2

Netherlands 5.0 2.2 3.6 3.1 3.7 4.5 4.4 3.9 1 2

Finland 7.7 2.8 6.9 6.4 8.2 8.4 7.8 7.5 1 2

Luxembourg 5.0 2.5 4.2 4.9 5.2 4.6 4.8 4.7 1 4

Belgium 7.7 2.6 7.5 7.0 7.9 8.3 7.2 7.6 1 4

Austria 4.5 1.9 4.4 3.8 4.8 4.4 4.2 4.3 0 3

Germany 6.8 2.2 8.7 7.5 7.8 7.0 6.0 7.4 -1 1

Unweighted

Average 10.8 2.2 3 4

Weighted

Average4 10.3 2.3 2 2

1Standardised unemployment (%), & HICP (%yoy)2

Absolute CPI deviation from 2.2% added to unemployment deviation from 5 year average

3Shaded areas show above average misery4Using adjusted GDP weightsSource: Hermes Fund Managers Ltd., based on Eurostat data and RBS projections (p)


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Political risk also remains an issue in the developing economieswhich are experiencing significant change that is also being broughton by the will of the people and economics. China does not haveenough resources, such as water. What impact will this have onits neighbouring countries? How will the US respond to this new

empire? All of these concerns feed into economics and consequently,investment pitfalls and opportunities.

Some may argue the much heralded era of globalisation minimisespolitical influence on a stock or securities selection basis. Notnecessarily. As national interest and protectionism increase, this willhave significant impact on companies and corporate interests. Therecent US Securities Exchange Commission actions against London-based Standard Chartered may be a case in point. Also, consider thedebt levels of many countries compared to the strength of corporatebalance sheets. How long will indebted nations allow companies toreap such profits without taking more of the pie for themselves? Willthey tax the companies or the shareholders? What if political changeaffects the way companies pay dividends?

The way we approach investments also has to change. Economicvariables such as GDP and interest rates are becoming too shallow ameasure of a countrys risk/reward profile. Long-embedded financialconcepts, such as mean reversions or efficient market theory, arealready lessening in importance. We are now approaching an erawhen one cannot make investment projections that do not take intoconsideration the actions of politicians.

The investment world needs to wakeup to the fact we operate in a politicaleconomy, not a hermetically sealedfinancial system.

Asset managers have to start employing political analysts and becomeas aware of politics as they are of economics.

Investors can make money in times of discontent and politicalstruggle; they just have to better understand the risks they maybe taking. There are opportunities to be found and there will bewinners and losers in this changing world; there is just a new set ofparameters that asset managers will need to consider.

UK real return on GILTS gross income re-invested 1900 2010 (End of year)

UK real return on equities gross income re-invested 1900 1952 (End of

year)


year)

Source: Barclays Equity Gilt Study 2011

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Year Event continued

1962 Cuban missile crisis

1963 JFK assassination

1964 US passes Civil Rights Act, Mandela sentenced to life

1965 LA riots

1966 Black Panthers established, anti-war protests in the US

1967 Israel launches pre-emptive strikes on Egypt, Syria and Jordan

and occupies Sinai and the West Bank

1968 Prague uprising, Tet Offensive

1969 First message ever sent via ARPAnet

1970 Spate of terrorist attacks



1973 Spate of terrorist attacks, Egypt attacks Israel in Sinai

1974 Ethiopian revolution, Nixon resigns

1975 Civil war Lebanon, Cambodian revolution

1976 Vietnam victory of the North

1979 Iranian revolution, Thatcherism starts

1981 AIDS, PC invented

1983 Star Wars, unrest in Lebanon

1985 Famine in Ethiopia, Gorbachev initiates Glasnost

1986 Chernobyl

1987 Black Monday

1989 Tiananmen Square

1990 Mandela freed

1991 USSR collapse1992 End of Cold War, LA riots

1993 Growth of internet

1994 End of apartheid, Mandela becomes President

1999 Euro launched, Panama Canal returns to Panama

2007 Global Financial Crisis

2010 Start of Arab Spring

Source: Hermes Fund Managers Ltd.

Saker Nusseibeh, CEO & Head of Investment at Hermes Fund Managers


year)

Key political events

Year Event

1900 US and Europe put down Boxer Rebellion

1905 Uprising in Russia

1911 Chinese revolution, Standard Oil broken up

1913 Assembly line in Ford factory

1914 Start of WW1

1917 October Revolution in Russia

1920 Bubonic plague in India

1922 Mussolini marches on Rome

1925 Mein Kampfpublished

1929 Stock market crash

1930 Ghandi 1930 salt march, Stalin collectivisation

1933 Hitler Chancellor, first concentration camp, end of prohibition

1934 Dust Bowl hits US farmland

1936 Spanish Civil War

1937 Japanese invasion of China

1938 Hitler annexes Austria

1939 WW2

1941 Pearl Harbour

1945 End of WW2, Germany surrender

1948 Apartheid, partition of Palestine, Gandhi assassinated

1949 Maoist China Revolution, USSR gets atomic bomb

1950 Korean War

1954 Segregation ruled illegal in US

1956 Great Britian, France and Israel attack Egypt

1958 Great Leap Forward

1959 Cuban Revolution

1961 Berlin Wall, first American into space

0

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Short-term policy measures have already been enacted to stopEurope from falling into the abyss but these have done little to solvethe long-term structural problems faced by the region. Investornervousness over Europe has grown over this lack of coherent,coordinated and clear policy and leadership.

Uncertainty kills investment and favours speculation. If companymanagement has no clear picture of the fiscal regime in the countryin which they are based, how can they make capital expendituredecisions with confidence? Companies do not operate in a vacuum,and at the moment, politics is an important aspect we must considerin our analysis. Politicians and the electorate are not always rational,so in this environment we have to focus on companies that will not bebuffeted by political squabbles.

Portfolios are focused on quality companies, those that are cashgenerative, have franchise value and/or brands and products peopleneed and which are somewhat immune from the health of theirnational economy.

We are picking companies we believe will still be here thriving in fiveyears time. It may be a clich, but even in crisis, the strong tend toget stronger. With the widening jaws of disparity between the weakand the strong, there is greater differentiation between companies,creating a great stock-picking environment.

Already, despite the crisis and the political decisions that are or arenot being made, Europe has provided positive returns for investors.European companies are yielding more than German bunds, M&Aactivity is up and over 18 months equities in the region have largelyoutperformed more favoured areas, like emerging markets.

Two-year Government Bond spreads1 2 (% points)

1 Vertical lines correspond to the first round of European Central Bank (ECB) longer-termrefinancing operations on 22nd December 20112 Spreads over German BundsSources: Bloomberg Financial Markets; national central banks; and IMF staff calculations

European EquitiesThe new Wild West: Why politics matters forinvestors in EuropePolitical activity and events in Europe, now the epicenter of the global

economic crisis, have become inextricably entwined with investmentideas and risks.

Before 2008, politics rarely featured as a consideration whenassessing investment ideas with the exception, perhaps, of the oil andgas sector where geo-political factors have always been an issue toponder.

The fallout from the financial crisischanged all that and the economic

situation of today is a political hot potatofew know how, or want, to deal with.

The problem is exacerbated in the eurozone where countries are tiedtogether by a common currency but possess disparate economic andnational issues.

The rigidity of the monetary union is amplifying divisions rather thanbinding countries together. No substantive decisions are being made,growth remains problematic and the debt burden continues to grow.

In analysing investment opportunities, we have been scenario planningaround two essential paths Europe may take: either full fiscal union,

or, a break-up of the eurozone and a return to free trade between thecountries. As a team, we are evenly split both outcomes are distinctpossibilities. In each eventuality, harsh political decisions will have tobe made. Germany is on the hook either way, so which direction it willhead remains difficult to predict.

Gross debt to GDP levels for countries in Europe vs the Maastricht Treaty

limit of 60%

Source: OECD Data & *Projections

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Maastricht Treaty LimitIrelandSpainItaly

GermanyGreeceFranceUnited Kingdom

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IrelandSpainFrance

PortugalItalyGreece 3 (right scale)


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Real private credit growth (year-over-year percentage change)

Sources: Bloomberg Financial Markets; national central banks; and IMF staff calculations

We have lived through an extraordinary period of stability, withoutconflict on our doorstep, and that has lulled us into a sense ofcomplacency that this is the natural state of being. Economic strifecan and does bring historically a whole legion of tensions. Recoveryrequires a long period and political intervention is necessary.Unfortunately, the steps needed do not necessarily sit comfortablywith election cycles. Welcome to the political economy.

Andrew Parry, Hermes Sourcecap

Money Market spreads1 (basis points)

1 Vertical lines correspond to the first round of European Central Bank (ECB) longer-termrefinancing operations on 22nd December 2011Sources: Bloomberg Financial Markets; national central banks; and IMF staff calculationsNote: LIBOR = London interbank offered rate; OIS = overnight index swap

Claims of euro area National Central Banks against the ECB (% of GDP)

Sources: Bloomberg Financial Markets; national central banks; and IMF staff calculations

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Euro LIBOR-OIS spread (three-month forward) L/H scale)

ECB deposit facility (billions of euros) (r/h scale)

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United States Euro area


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$1,200

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3Jan12

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ay12

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30Aug12

Dispute escalates resulting in violentclashes on the 17th of August

Platinum

mandated percentage of corn used in ethanol production in the UScould be changed as a result of its dry summer; and there have beenfatal mining clashes in South Africa, impacting the price of platinum.

Platinum Price

Source: NYMEX, Bloomberg, Hermes Commodities

In our portfolios, we are vigilant in assessing the political risks for eachcommodity leading us to over or underweight certain areas of themarket.

We continually monitor global political activity, assigning probabilitiesof events and supply/demand patterns that could alter prices. Our ownanalysts conduct the bulk of this work but we also employ geopoliticalconsultants who help us to stay informed on what politicians aresaying globally, the levels of military mobilisation and to monitor billsbeing passed. Longer-term political impacts, such as changes inenvironmental legislations, are obviously easier to factor into pricesand keep abreast of than the shorter-term issues like the SouthAfrican mining clash.

Information from these external and internal sources is fed into ourprocess and we then strive to use this to form our views.

Colin OShea, Hermes Commodities

CommoditiesBeyond borders: Why commodities investing goesbeyond geo-politicsCommodity prices have always been influenced by political events

but more so today than we have seen in decades. Increasedenvironmental legislation and tensions between global nations areintersecting frequently with greater resource demands to build anuncertain climate.

The biggest political risk we see at the moment is within the energysector, with a potential conflict between Israel and Iran. During thesummer the increased tension between the two countries over theenrichment of uranium led to a strong surge in the oil price, from $89to $1151 in a two-month period and it may not be the last of it. Movingforward, the outcome of the US election in November may also impactthe Israel/Iran situation. However, whether it is for the worse or thebetter is difficult to say at this point.

The oil implications of any open conflict between these two countriesare critical and any shutdown of oil coming from Iran would haveserious ramifications on world supply and prices. This threat isperhaps more severe than we have seen in some time due to theamount of posturing and rhetoric coming from both sides. Hardstatements are being made.

Many of these regions are suffering from chronic unemploymentand food inflation, leading to civil unrest and adding pressure ongovernments to keep the oil price high in order to balance their ownbudgets. Egypt, Syria and Sudan are all examples of turmoil that hasand will affect future oil supply. Oil fields located in the middle of Northand South Sudan have created disputes that have already manifestedinto armed conflicts.

While Middle East instability has alwaysaffected oil prices, today there is a clearand present danger of a big event thatcould severely disrupt supply.

If we had projected the potential of something happening on a scaleof 1-10 over the past 20 years, other tension-riddled periods wouldmaybe have rated 5-6; today we rate the probability of somethinghappening around 8-9.

Oil is not the only commodity where the political situation is interferingwith the supply/demand picture and consequently, prices. Liquefiednatural gas exports from the US rely on permissions dependent ongovernment policies, which could change post the November USelections; Russia has experienced a dry summer and combined with agrowing protectionist stance could restrict wheat exports; the

1Source: Opening price on 21 June to closing price on 23 August 2012, ICE & Bloomberg


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JGBs outstanding and the portions held by the BoJ and banks

Source: Thomson Reuters Datastream

Chinas growing importance and the growing Asian wealth equationalso has implications for Japan. If the China/Japan relationshipwere to deteriorate, there is no doubt that it would affect Japanesecompanies. However, the reliance of other economies on Chinasgrowth is no different in this respect from Japans.

Political risk is not quantifiable but we remain as aware of it as otherpotential risks, especially changing business models. For instance,Japanese companies, hampered by the countrys aging populationand work force, are spending more on R&D and developing new

production methods.

One thing Japans 2011 earthquake and the Thai flood highlighted isthat the country is vulnerable to disruptions in supply chains, but suchevents are impossible to predict and de-risk from entirely.

Jonathan Greig and Andrew Friday, Hermes Japanese Equities

JapanStable boat, choppy ocean: Political risk in JapanJapan is one of the most politically stable markets in the world, sodomestic political risk for equity investors looks quite small. However,

from a bottom-up point of view, international politics is a factor inour assessments as Japanese companies contend with the tradingdynamics of the growing Asian economies as well as issues of astrong currency.

Unlike countries, such as the US,where the public often forces politicalchange, in Japan maintaining thestatus quo is the norm.

There has been little difference in the countrys one partygovernmental system for five decades now and it has shown littleinclination to change the way things get done. Japan is a consensusnation; they do not like to rock the boat. This can be both a positive anda negative for investment prospects in the country.

In our view, the Bank of Japan (BoJ) is one of the most independentlyminded central banks in the developed world. Unlike the FederalReserve or the Bank of England, it does not have an inflation targetthat it adheres to rigidly. There is no discernible move to meet the 1%inflation target set in February this year.

At the sector and sub-sector levels there are political considerations

we must assess in the form of changing regulations, but by andlarge these are often positive for businesses. For instance, Japandoes not allow casinos, but a gaming rules change could lead to newopportunities while de-regulation in the telecom sector could enablecompanies to have greater pricing control.

Where we do look at political impact and risk is that originating fromthe international community. Currency movements are a derivativeof political influence. Since the financial crisis, many economieshave been working to engineer a weaker currency to help boostexports and promote growth. Japan has been on the losing end of thisbecause other central banks have been more proactive in aggressivelytaking steps to offset the financial crisis. The USs Federal Reservehas been creating and adding monetary disequilibrium to an alreadyunstable situation, but then, they are willing to take the risk themuch more conservative BoJ is not.

While Japan would certainly benefit from a weaker yen, it does notnecessarily have the tools with which to manipulate its currency.Japan has one of the highest debt to GDP ratios among westerneconomies. It should be a Greece, but with over 90% of its nationaldebt in domestic hands, confidence in Japans credit worthiness is stillhigh, as reflected in low government bond yields. The rest of the worlddoes not own enough of Japans debt to force change.

92 94 96 98 00 02 04 06 08 10 12

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Whether/which governments if any will alter operating conditionsfor real estate investors in the new reality?

While real estate is predominantly a local investment, globalisationand the greater accessibility of property in other countries, as wellas the interconnectivity of world events have given rise to more

international influences. A prime example of this has been the eurocrisis, which has led many investors to seek out safe haven assets andregions. The prime London property market, including residential andcommercial assets, has been a beneficiary of this, as evidenced by theincreased number of overseas buyers.

This trend may be a positive right now but some believe such capitalinflows, based on the desire for exposure to an income-producingasset in a safe haven market, will be more footloose, and once theworld rights itself once again that money could flow back out. Weremain convinced the case for London is a strong one and thatthe majority of todays investors will be attracted to fundamentalcharacteristics of the market and not just as a tactical safe haven play.

Central London ofce investment Q2 2011 (%)

Source: propertydata.com

Central London ofce investment Q2 2012 (%)

Source: propertydata.com

Real EstateLondon Calling: Why London remains a safe havenfor real estate investorsDirect real estate is susceptible to a high degree of influence from the

full spectrum of politics from local to international.

As with other asset classes, the challenge of real estate investing is tounderstand where pricing is at (and where it is going), which comesback to assessing real estate market risks plus a combination ofboth political and economic risks. Much hinges on national laws thatcan affect a propertys certainty of title as well as tenant demand andincome security, but equally important in the assessment of value areplanning laws - decisions that are often determined at the city/districtcouncil level.

Taxation is one area that obviously has impact on real estate and it isalways subject to change, likewise the regulatory environment can beburdensome but is something we have always monitored and gauged.

However, today there are also a widerange of high level political/economicrisks/issues investors are struggling toassess effectively, each of which couldhave significant impacts on local realestate prospects/risks. These include:

Political/economic risks/issues

Macro

Instability in China

Eurozone break-up

Middle East instability

US debt

Impacts of austerity measures

Legislation

Basel III

Solvency 2

On top of these issues is the need to spend more time evaluating howthe markets will adjust and recover in the face of the quite exceptionalconditions they currently face.

How banks will adjust to new capital adequacy requirements andtheir appetite to provide real estate debt?

The impact of bank deleveraging and management of their non-performing real estate loans?

New sources of real estate debt will they be sufficient?

Strength of occupational demand (public and private sector) in faceof weak fundamentals and low levels of business and consumerconfidence?

Overseas 58

Private Individual2

Other4

Institutions17

Quoted Property Co. 10

Private Property Co.9

Clockwise from top:

Overseas78

Private Individual3

Other3

Institutions6

Quoted Property Co.5

Private Property Co. 5

Clockwise from top:


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Still, the strong demand for safe haven assets has driven pricing atthe prime end of the property market. In this climate we see moreappeal in assets where we can add value and create prime frommore secondary properties and regeneration opportunities in areasof central London benefitting from infrastructure improvements and

expected long term sustainable demand.At Hermes, we are predominantly invested in the UK market withnearly 90% AUM in the domestic market. However, we have aprogramme to diversify our exposure internationally and in the courseof this we evaluate political risk as a key consideration in our marketassessments and specific investment decisions. We expect to continueto favour the more mature markets even though the impacts frompolitical risks (from international to local) could be greater in thesemarkets than in the past.

Worlds most transparent markets

Transparency level Global rank Market Composite scoreHighly transparent 1 United States 1.26

2 United Kingdom 1.33

3 Australia 1.36

4 Netherlands 1.38

5 New Zealand 1.48

6 Canada 1.56

7 France 1.57

8 Finland 1.57

9 Sweden 1.66

10 Switzerland 1.67

Transparent 11 Hong Kong 1.76

12 Germany 1.80

13 Singapore 1.85

14 Denmark 1.86

15 Ireland 1.96

Source: Jones Lang LaSalle, LaSalle Investment ManagementNote: Scores shown rounded to two decimal places; rankings are based on unroundedscores

We will continue to carefully monitor local operating conditions in allmarkets in which we are invested. Outside the UK we aim to work

alongside strong local partners who have an on the ground presenceand local knowledge, providing us with the local eyes and ears andnecessary insights into local market operating conditions.

Chris Taylor, Hermes Real Estate


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On a macro view, 2012 has been a big political year with electionsin countries like France, Greece and Russia plus we are still feelingthe effects of the Arab Spring; all the while global growth continuesto struggle. There is no doubt there is a lot going on. Nevertheless,we cannot just run away from countries because of the change they

are going through. As investors, we need to remember change is notalways a negative, and regulatory and political interference can also bebeneficial.

Major elections held in 2012

Country Date Outcome/type of forthcoming election

Russia 4 March Vladimir Putin elected as president

Greece 6 May Inconclusive

France 6 May Franois Hollande, Socialist Party ousted

incumbent Nicolas Sarkozy

Egypt 16 June Muslim Brotherhood's Mohammed Morsi

became Egypt's first freely elected president

Greece 17 June Antonis Samaras, New Democracy

Iceland 30 June Serving president Olafur Ragnar Grimsson

won a fifth term

Libya 7 July Former interim prime minister Mahmoud

Jibril won the country's first democratic

election

China Autumn Leadership change in Communist Party (see

2013)

Netherlands September (general election)

Venezuela October (presidential election)

Lithuania October (parliamentary election)Ukraine October (parliamentary election)

Romania November (parliamentary election)

Sierra Leone November (presidential election)

Slovenia November (presidential election)

US November (presidential election)


Global EquitiesWhy looking under the bonnet matters whenbuying global equitiesWe have entered a period of increased political uncertainty but this

does not automatically equal higher risk. By working to understandthe implications of global changes and taking a long-term investmentview, we strive to identify not only the risks present, but also theopportunities.

Politics and regulatory risks go hand in hand and both tend to be moreinvasive after a big event, such as the global financial crisis. There is noblanket approach to de-risking entirely from political events, as manyare largely unknowns until they occur.

The one thing we can not do in such

an environment is automatically avoidcompanies in a country or sectoraffected by increased regulationor political unrest. Political andregulatory influence can create asmuch opportunity as it can hurdles on abottom-up basis.

As such, we look to explore various scenarios and outcomes from

political events and then weigh it against stock specific and othereconomic factors.

Investing globally can mitigate some country-specific political issues.Certain sectors may offer greater opportunity in one region than inanother, although this is not always the case. Sectors like utilities,telecoms and financials, to a certain extent, involve a high degreeof domestic regulation. However, sectors like healthcare haveperhaps more global influences. US healthcare companies may lookunattractive at the moment due to uncertainty on the US political front,however, European pharmaceuticals are not immune from this aslarge portions of those businesses sell into the US.

Within each sector there are numerous policy changes that can

impact investment opportunities. We need to try and understand,on a case-by-case basis, how much of a variable each policy may beand then examine its potential impact. News can understandablyshake ones confidence in certain market areas but it should not driveinvestment decisions. For instance, one of the latest blows to thebanking sector has been the Barclays/Libor scandal in Europe, withannouncements that now a further 14 banks are being investigated.This has caused further risk aversion over banks but what manyinvestors overlook is that there are also hundreds in Europe aloneunaffected by any such investigation.


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Forthcoming elections in 2013 (alphabetical)

Country Type expected and date

Australia General election, expected Sept/Oct

Austria Parliamentary in September

Chile Presidential in December

China Leadership change in the ruling Communist Party

typically occurs once every 10 years. Although decided

in 2012, new leaders do not take over until 2013

Cuba Parliamentary in January, presidential expected

Cyprus Presidential in February

Czech Republic Presidential in February

Ecuador Presidential expected

Germany Parliamentary expected in September

Iceland Parliamentary expected

Iran Presidential in June

Israel Parliamentary in October

Italy Parliamentary in April and presidential in May

Japan Parliamentary in August

Norway Parliamentary expected

Pakistan Expected parliament and presidential


Yes, there are some sectors and countries we will not touch becausethe political risks are too high and there is no attractive trade off

available. As part of this, we prefer exposure to countries where thereis greater consistency in regulation. In the main, for us it is aboutdigging down and having the research support to be able to see moreclearly as to what change is plausible, what the ramifications may trulybe and then trying to identify the winners and losers.

Although the current turmoil may appear to contain only bad news,it is worth remembering we are in the grips of the fear portion ofthe greed and fear investment principle, which can exaggerate allrisks. We must not be complacent about political risk there is moreuncertainty and slower growth today, which can lead to more violentreactions and surprises. However, at the same time we should not beruled by short-termism.

The best any of us can do is to know as much as possible and assessthe risks, thereby building a portfolio to insulate from such risks.

John Chisholm and Lode Devlaminck, Hermes Global Equities Advisors


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High youth unemployment, which is at 54% in Spain, is typically oneof the two main ingredients for civil war (the other, historically, is badharvests). While we are not suggesting war is likely to break out, itdoes highlight the difficult situation for Spains politicians. Adding tothe problem is the shortness of election cycles these days, meaning

any government in power may not even be around long enough tointroduce the reforms they promised. Investors may feel protectedfrom the situation by merely avoiding Spanish debt but let us not forgetthe threat of the contagion it poses.

Unemployment rates of males under 25

Source: Thomson Reuters Datastream, based on Eurostat data

Ultimately, it is the inability to print more money hindering theeurozone. The US has an even greater debt burden than the eurozone,but its ability to print money lessens concern it will default, bolsteringTreasuries (and UK gilts) status as a safe haven destination in theworld of government bonds.

The present threat of default and downgrades springing from thedebt and political situation in many of the G12 economies is veryreal. In recent years, virtually all the countries we monitor have beendowngraded with exceptions being countries such as Canada, Swedenand Australia.

These economies have had some important things in their favour:their banks were more robust going into the 2008 crisis, thus requiringless support, solidifying their sovereigns fiscal positions, and offeringrelatively lower default risk than others. These combine to leave themwith a more stable political situation.

Global Government and InationBondsIn the driving seat: How governments drive bondmarketsPolitics is important to all investments, but within the sovereign debtmarket it is pervasive. Governments drive policy and policy drivesbond markets. However, where policy instability and default risks mayonce have been more relevant to emerging markets bonds, of primeconcern today is the debt issued by developed economies.

The political direction of many countries is currently in a state of fluxwith key elections and leadership changes coming in the US, China,Australia, Japan, Italy and Germany - all before autumn 2013. Whilethe election landscape is always important, these days there areheightened ramifications. In previous decades there may have beenwidespread political risk between countries; today it is more withincountries as social unrest grows.

High unemployment and slow economic growth combined withausterity measures to lower the debt levels in many countriesis breeding discontent. Therefore, the outcome in each of theseupcoming political events is a potential force of instability.

Leadership, though, is just one aspect we must consider. Theregulation politicians enact can be just as harmful as they are helpfulto bond markets. For instance, we are carefully watching liquidityconditions in the bond derivatives market, which could be hamperedby the step up in banking regulations.

In the current climate much of the endemic problems regardinggovernment bonds, be they low yields or investor nervousness, are

originating in the eurozone. The situation has become untenable andthere appears to be little solution in sight. Spain is a prime example ofthe powder keg the eurozone is fast becoming.

If you were worried about the level of debt in Greece a few years ago,then you should be doubly worried about Spain today. However, thecountry is between a rock and a hard place. If its politicians do notimplement much needed reforms then downgrades are inevitableand its economy will have an even harder struggle to get out fromunderneath its mounting debt issues. Yet, if the Spanish governmentdoes institute deeper austerity measures such actions could lead togreater social unrest.

Mixed competitiveness since the euro

Change since Jan 2000 in relative unit labour costs, vs c/acc shift as % GDP

1Greece from 2001 when it joined the euroSource: Hermes Fund Managers Ltd., based on OECD data

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Eurozone weighted avUK

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No G7 country has loosened macro-economic policy more than the UK

Shifts since 2000 in real rates (using CPI, 3m Libor) & structural budget

decits

Source: Hermes Fund Managers Ltd., based on OECD, IMF, & Bloomberg

Political risk has always been a fundamental part of our investmentprocess. However, we believe today we are in largely uncharteredwaters with many unstable elements.

Politicians are being forced into eitherunpopular decisions or ignoring thosethat need to be made.

Rising Middle East tensions are pushing up the price of oil, emergencymeasures taken by central banks in the form of quantitative easingis adding inflation fears and escalating regulatory pressures arepotentially encumbering to bond markets liquidity. Until somethingsignificant changes we continue to monitor key election dates andpolicies and maintain a selective, rather than all-encompassing,stance within our portfolios.

Penni Coe and Neil Williams, Hermes Global Government and Inflation Bonds

-12-11-10-9-8-7-6-5-4-3-2-101

23

-8.00 -6.50 -5.00 -3.50 -2.00 -0 .50 1.00

Tighter

Looser

US

Japan

Eurozone

UK

Canada

Shift in real rates (% pt)

Fiscal shift(% of GDP)

NB: Excluding all liquidity injections

Germany

Sweden

Australia

NZ


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Despite these and other concerns and continued market volatilityin the face of political influence we are still finding opportunities. Itis clear we are in a world of financial repression, which is creatingyield-hunger that makes some asset classes attractive, and so wehave a preference for beaten up assets that offer an attractive yield

such as RMBS. As we believe markets, driven by political concerns,will continue to fluctuate we are also looking at managers able totake advantage of the ebb and flow of correlations, such as statisticalarbitrage funds. Liquidity is lower than pre-2008 and continually underthreat by new financial regulations so we also prefer much smallerhedge funds, those capable of being more nimble.

HFR Indices in Risk-On/Risk-Off Environment

Source: Bloomberg

The world may be experiencing unprecedented and complex politicalshifts, but with change also comes investment opportunity. A lot ofnoise out there is just that, noise and ultimately fundamentals willprevail eventually. Yes, regulations are changing the manner inwhich the funds we invest are managed. However, at times like thiswe need to remember markets and market participants have anextraordinary ability to evolve, and the hedge fund and investing worldis nothing if not adaptive. A new equilibrium between regulation,policymakers and the investment world will be found, although in the

meantime we do have to be cognizant of the tensions that lie at theheart of all this change.

Mark Barker and Tommaso Mancuso, Hermes BPK Partners

Hedge Fund SolutionsWhite noise: How to cut through the politics andnd returnsIt is hard to overstate the significance politics has on markets these

days. Geopolitical issues, such as tensions in the Middle East, maybe something investors are accustomed to assessing with regardsto risk, but today we must also contend with the influence of themainstream political landscape, especially in Europe.

Policymakers and politicians havealways had an impact on marketmovements; however, they have notbeen a primary driver the way they are

today. Every significant market move inthe past three years has been a resultof political rhetoric or action.

The overused phrase of current market conditions, risk-on/risk-off,is a function of political risk in markets. When the world believespoliticians are doing something seen as broadly sensible, theninvestors return to fundamentals and markets are buoyant; whenpolicymakers are at an impasse or taking what is deemed as perhapsa less than sensible approach, correlations rise and the marketbecomes driven by technical factors once more.

Exacerbating the problem are the unsychronised political cycles.Within most governments there is a limited period within whichthey have the political capital to get things done. With 17 eurozonegovernments it is extremely challenging to build a consensus betweengovernments that have the political capital to push tough decisionsthrough. If unity is needed to resurrect Europe as a whole, thengovernments will need to work together. However, while say Francesrecently elected Hollande government has the political capital to getthings done right now leaders in Germany, facing an election nextyear, may not.

There is no painless solution to the economic troubles most countriesface, so the electorate is bound to be consistently disappointed.

Electorates have been and continue to react to this by voting in newgovernments, shortening political cycles and reducing political capitaleven further. We believe this may be the case for a decade at least.With such rapid swings in the political pendulum there is a worry wellreturn to 1970s-style politics, where governments without a definitemajority have unclear mandates and where no one will be happy withthe policy decisions being made.

Increased regulatory risks accompany political change. Since 2008 ourown industry, hedge funds, has been impacted by various politics-ledpolicy changes, from short selling bans to banking changes affectingliquidity. Of concern to us in this area is the potential for an expansionof short-selling bans to sovereign paper. If a manager is looking tohedge out risk, and today one of the greatest risks is sovereign default,

then a ban in this area would be significant. In addition, the law ofunintended consequences is that a limited ability to hedge risks couldcause managers to reduce bets in their long book as compensation,further stifling investment.

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Emerging MarketsHidden gems: Why political risk is an opportunity inemerging marketsPolitical risk in emerging markets has been steadily growing since

2008 and is one of the top risks we analyse, although this is a complextask.

A sense of historical perspective is necessary to understand politicalchange, but as politics are not mathematical one cannot model orforecast such change the way one can for economic variables. Inaddition, many global emerging markets (GEMs) have only been viableinvestment destinations for the past 20 years, so there is little longterm data on which to base forecasts as to how a country will respondto changes.

Political issues in emerging markets vary widely, depending on theirgeography, level of industrialisation, urbanisation and heritage. Formany GEMs political stability is a recent phenomenon and as such

at times political disruptions are not as damaging to investmentopportunities as they may first appear. For example, Thailand haswitnessed a very high number of coups in the 20th century 18-20*by some counts but several of the recent coups have led to buyingopportunities as little changed fundamentally.

A lack of understanding of the underlying strengths of an emergingeconomy can also lead investors to retreat too quickly. Indonesia,during the 1997-98 Asian crisis, looked set to become a failed stateas it suffered riots, a crashing currency, and a profound change inpolitical leadership. Despite an 86% crash in the currency in late 1997and early 1998, the rupiah eventually stabilised, as importantly did thecountrys GDP. The country has since experienced positive growtheach year since 2000, including the years of the global financial crisis,

to the surprise of many investors.

Indonesias recovery

Source: Thomson Reuters Datastream

So what has changed with regards to political risk today and why is itagain on the radar screen? Because the economic downturn is global

this time; the west, which previously provided backstop support foremerging economies, is in need of rescue itself, leading to far moreunknowns. Debt in the safe or backstop economies has soared. Forexample, in the past Spain could be counted on to invest heavily in

Latin America during a crisis whereas today, considering Spains owneconomic struggles, such action would seem unlikely. Unemploymentis now above 20% and Spanish companies are being forced to divestinvestments they made in previous crises.

As economic woes mount globally, the risk of disruptive changes inthe political landscape rises. Per capita GDP growth and inflation aretwo drivers for a happy population. As long as people feel their livesare improving they tend to be tolerant of their government; as wecan see in Southern Europe today, the moment this picture begins todeteriorate political risks start to rise.

Country analysis remains a top consideration in finding investmentopportunities in emerging markets. At Hermes, we take anintegrated approach, examining both country dynamics and stockspecific influences. Most of the top down work we do focuses onmacroeconomic factors such as trade, money supply, and growth.However, our country specialists also analyse political issues to aid usin asset allocation decisions.

In the current environment we are biased towards more maturecountries where there is greater visibility and history to provide contextin the analysis of current events. However, we do not discount buyingopportunities that can be had in regions that are more up and coming,such as Vietnam, Bangladesh, Nigeria and Pakistan.

From a stock specific point of view, we target quality companies at adiscount, ideally with a global franchise. In GEMs, however, there arefew global powerhouses, so companies, by and large, remain moreexposed to domestic issues than those based in the US or Europe.

As policy is intricately linked to the economy there are lead indicatorsthat allow us to identify vulnerabilities that may arise. For instance,the Arab Spring was preceded by a rise in food prices. As standardsof living ebb, tensions and unrest grows. While some could argue thechange in some of these North African nations experiencing unrestmay, in the long run, be a positive, for now investors will avoid suchregions. If you would not dare visit such places, why would you want toput your clients money there?

Gary Greenberg,Hermes Emerging Markets

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DisclaimerThe views and opinions contained herein are those of individuals, and may not necessarily represent views expressed or reflected in other Hermes communications, strategies orproducts. The information herein is believed to be reliable but Hermes Funds Managers does not warrant its completeness or accuracy. No responsibility can be accepted for errors of factor opinion. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations.

This document has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. This document is published solely for informationalpurposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments.

This communication is directed only at recipients who are eligible counterparties or professional clients, as defined in the Glossary to the Financial Services Authoritys Handbook of Rulesand Guidance. Hermes Investment Management Limited has its registered office at Lloyds Chambers, 1 Portsoken Street, London E1 8HZ. Hermes is a multi-boutique asset manager,independent of any broader financial services organisation. Each Hermes operating company is either a subsidiary of, or is otherwise affiliated to, Hermes Fund Managers Limited.

Figures, unless otherwise indicated, are sourced from Hermes.

The distribution of the information contained in this document in certain jurisdictions may be restricted and, accordingly, persons into whose possession this document comes are requiredto make themselves aware of and to observe such restrictions.

CM108612 NonUS 09/12

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Hermes Thought Piece Political Risk CM108612