In January, Egypt, the most populous country in the Arab world, erupted in mass protests against President Hosni Mubarak. After 18 days, Mubarak resigned and turned over all power to the military. While the events have widespread implications for U.S. foreign policy, for investors the most important concern may be the potential for instability to spread further across the Arab world. More recent events include an uprising in Libya and protests in Yemen, Bahrain, Iraq, and the West Bank.

The tradeoff: Economic health for political freedom
At certain points in economic development, people are willing to trade political freedom for improved economic well-being. China is an example of a country that has enabled significant improvements in the economic health of the population in spite of its one-party political structure. However, in almost all of the Arab Muslim world, we generally see no economic improvement under repressive dictatorships. These are unstable systems, and inevitably such systems will be undone. That is what we’re witnessing now.

Demographic challenges spark economic failure
One reason these autocratic regimes fail economically is demographic pressure. The percentage of the population in the Middle East that is under the age of 30 is a staggering number — ranging from 50% to 60%, depending on the country. When a society is that lopsided demographically, generating jobs for all the young people becomes extremely difficult, especially if you don’t have a vibrant economy that is free of corruption.

Surging commodity prices
Commodity inflation also contributed to the unrest in Egypt, which is the world’s largest importer of wheat. As commodity prices surged upward, the government was being pressured, as it was when we saw food riots in 2008 — the last time commodity prices peaked. And while this inflation was a contributing factor, it was just one of many interrelated issues that contributed to the recent turmoil in Egypt.

Implications for investors
The big question, in my view, is what happens if the dominoes start falling elsewhere? As an investor, the countries that concern me most are Algeria, Yemen, Libya, and Bahrain. Algeria is a large exporter of natural gas to Europe, and was poised to become a very large exporter of fertilizer to Europe. Algeria should matter to investors, especially those with European exposure.

Yemen has an Al Qaeda problem, on top of its inability to deliver economic well-being to its population. Yemen is also a border state to Saudi Arabia, as is Bahrain in the Persian Gulf. As unrest surrounds the countries that export a large portion of the world’s oil, the implications for investors become more pronounced. Higher oil prices also act as a tax on global consumers, slowing the consumers’ contribution to economic recovery.

Putnam Emerging Markets Equity Fund had no exposure to Egypt
We had liquidated the fund’s positions in Egypt before the protests erupted. We believed that valuations had run their course and that rising commodity prices and inflationary pressures would lead to slower economic growth. I was very concerned about Egypt’s ability to manage through these issues. In addition, because of the Dubai financial crisis in 2008, we had also eliminated our exposure to the Gulf Cooperation Council, which consists of the six Persian Gulf countries, excluding Iran.

Managing an emerging-markets portfolio today
The events in the Middle East underscore the importance of our active management strategy. Many international portfolio managers focus on only two dimensions: sectors and stocks. We add a third dimension — top-down country analysis. As part of our process, we look not only at economic cycles, but at the politics, the economic policies of the governments in place, the policies being proposed by the opposition, the sustainability of the current regime, and the transparency of the leadership. Countries that don’t score well from this top-down perspective become less attractive in our investment process.

Consider these risks before investing: International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Additional risks may be associated with emerging-market securities, including illiquidity and volatility. The fund may invest a portion of its assets in small and/or midsize companies. Such investments increase the risk of greater price fluctuations. The use of derivatives involves special risks and may result in losses. Growth stocks may be more susceptible to earnings disappointments, and value stocks may fail to rebound. The market may not favor growth- or value-style investing.