By the end of the 20th Century, the Iron Curtain had been torn down in Europe and the world appeared to be heading for new era, free of geopolitical tensions. Yet 2020 has proven there are just as many market-shaking events now as there was in the past. What’s more, they seem to be on the increase.
Already this century there have been three geopolitical earthquakes: the 2001 9/11 terror attacks, the global financial crisis and now the COVID-19 pandemic. In addition, there has been a rise in populism throughout the developed world that has seen Donald Trump elected president of the United States and the decision of the UK electorate to leave the European Union.
A partial retreat by the United States from its post-war role as global policeman has left the way open for China, Russia and Turkey to push ahead with their regional and global ambitions. China’s increased influence as part of its Belt and Road re-enactment of the ancient Silk Road trading route is causing concern, as is the refugee crisis stemming from the Iraq and Afghanistan wars and the chaos in Syria.
Other than these, there are simmering tensions in Italy that may, down the line, threaten more fragmenting of the European Union, there is the ever-unpredictable North Korea, tensions over Iran, the constant danger of terrorist attacks, the potential for major cyberattacks, and so on.
Geopolitical shocks can have major impacts on markets across different asset classes and geographies, and the challenge for the investor is to minimise risk by being as well informed and prepared as possible.
The risks can be broadly categorised between those that come as a complete surprise, such as the terror attacks on the United States in September 2001, those that have been simmering for some time, such as U.S.-China trade tensions, and those that happen on a certain date, such as the Brexit vote. While the terror attacks came out of the blue and would have not been priced into markets to any extent before the event, some of the trade tensions and the Brexit vote would have been anticipated and would therefore already be partially priced in.
Each type of risk needs to be prepared for differently.
Impact from geopolitical shock can be short-lived
A sudden shock such as a major terrorist attack or outbreak of war can have an immediate impact on market confidence, causing capital flows out of risk assets and into safe havens such as cash, gold, bonds and defensive stocks. However, although the hit to markets can be dramatic, it is frequently short-lived once markets have had time to assess what the likely impact is on economies and asset prices.
Depending on where a terrorist attack takes place or who is directly or indirectly involved in a war, there is likely to be some impact on demand through a drop in consumption or disruptions to supplies. The impact will be particularly marked in export-driven economies.
However, for stock markets in developed countries, there will also be a host of other factors to be considered by investors when buying or selling shares, such as monetary policy, economic data and corporate results, which are likely to take precedence in investors’ minds once the initial shock has passed. Even after something as pivotal as the 9/11 attacks of 2001, which caused a near 12 percent drop in the S&P 500 Index in the week following, all of the market’s losses had been recovered within 25 business days.
If the overall economic conditions are strong, the losses are likely to be absorbed by the market. Even during 2020 as the COVID-19 pandemic has been raging across the world, U.S. equities have more than recovered from their enormous March losses.
When markets have suffered a long-term decline after a geopolitical shock, it is often the case that there were other negative factors involved in the slide. The market decline after the oil price shock of 1973, for example, came against the backdrop of Watergate and high unemployment. Similarly, the bombings of two U.S. embassies in Tanzania and Kenya came at the height of the Asian financial crisis and as Russia defaulted on its debt.
Long-simmering risks require a longer-term outlook
Some geopolitical risks play out over a longer timeframe and demand a longer-term investment position. The U.S.-China trade war and the protracted departure of the UK from the European Union are two such examples.
Business capital spending growth has stalled since the EU referendum in June 2016, having already been below forecasted expectations before the vote. As a result, economic growth in the UK has slipped from above to below the G7 average and the FTSE 100 has underperformed world equity markets.[i]
The market effects of the U.S.-China trade war are more difficult to discern as the economy has held up well during Donald Trump’s presidency, but there are longer-term implications of the trade war with the suspension of capital investments by many firms that are concerned by the direction of future trade. The war may be supportive of U.S. equities to some degree as tensions with China have had a knock-on effect on emerging markets, which has seen some redirection of capital towards the United States.
The strength of U.S. equities during the trade wars also demonstrates the resilience of economies that are more domestically driven than those such as emerging markets, which rely more heavily on international trade, even when they are at the centre of the geopolitical risk.
Forex impacts more dramatic in commodity and export currencies
The most dramatic effects of geopolitical shocks are often felt in the currency market. When investors sell off shares as a crisis breaks, they often re-allocate into safer assets in their domestic currency, but international investors frequently leave the economy altogether and convert their assets into other currencies.
Some currencies can rack up heavy losses, particularly commodity and export currencies, as has been seen during the COVID-19 pandemic. This is because investors fear a protracted period of risk in a key region or economy would ultimately impede economic growth and thus demand for raw materials and goods. This can impact not just currencies of emerging markets, but commodity currencies such as the Australian, Canadian and New Zealand dollars. Cautious investors instead move money into the safety of the Swiss franc, yen, U.S. dollar and increasingly the euro.
Investors need to trade quickly on geopolitical events as markets can move very fast, and re-allocate between asset classes and geographies, which may be moving very differently from each other. Equity investors will also need to quickly consider the implications for specific stocks and sectors. Although, for example, there was a massive stock market decline in March when the global scope of COVID-19 began to become apparent, technology stocks were about to soar to unprecedented levels.
But better than moving once the event has happened is being prepared beforehand. There are a number of political and country risk reports available and all sorts of geopolitical news and analysis. There are also available barometers of geopolitical risk such as the Geopolitical Risk (GPR) Index by Caldara and Iacoviello. This provides a benchmark indicator of news headlines related to geopolitical tensions, wars or terrorism based on automated text-search results of the electronic archives of 11 national and international newspapers.
Investors should also prepare themselves for major adverse events by devising a comprehensive investment strategy for the most likely or impactful geopolitical risks. This would first mean listing the current risks (and being aware that this list is constantly changing).
Having listed the most likely adverse risk events, investors should analyse each in terms of potential adverse outcomes and the likelihood and potential market impact of each scenario. This includes determining the extent to which each event is already priced in by markets.
The next step is to estimate what impact there might be on profits and losses for each affected asset based on an analysis of current market conditions and historical data.
Finally, the risk assessment made should be applied to the portfolio to ensure it is diversified well enough to minimise losses.
Geopolitical situations can change fast, so keeping on top of developments can require a significant commitment of time and resources. However, the potential for massive market impacts cannot be underestimated and it is essential that investors are as fully prepared as possible so as to minimise losses and keep investments on track.