What the return of Middle East tensions could mean for markets

The recent assassination of Qassem Soleimani, the head of the Iranian Revolutionary Guards’ overseas forces, has reignited tensions in the Middle East and sent tremors through asset markets.

The oil price rose sharply to over USD $70 a barrel in the first week of January, amid concerns that tensions in the region will impact supply.

Meanwhile, the value of assets perceived as “safe havens” such as gold, the Japanese yen and US Treasuries has also risen. Indeed, the price of gold at one point hit its highest level since April 2013 (USD $1580 per troy ounce on 6 January 2020).

So far markets have responded as one might expect if you look at previous bouts of heightened geopolitical risk.

With geopolitical risks on the rise, they can significantly impact investment returns and may play a major role in the years to come. 

• Geopolitical risk creates uncertainty that weighs on economies and financial markets, triggering investors to move away from 'riskier' assets. 
• Analysis from Schroders shows that in 4 out of 5 periods of geopolitical risk a 'riskier' portfolio outperformed the 'safe' portfolio after the risk subsided.  
• With the scope for central banks to ease monetary policy less than in previous episodes, taking geopolitical risk into account when choosing portfolio strategy will be increasingly important for investors.

What do we mean by geopolitical risk and how does it affect economies?

Geopolitical risk can refer to a wide range of issues, from military conflict to climate change and Brexit. The risk occurs when there is a threat to the normal relationships between countries or regions at a political, economic or military level.

Geopolitical risk creates uncertainty. This weighs on economies and financial markets as decision-makers hold off from making major commitments.

How does it affect markets?

Geopolitical risks tend to trigger investors to move away from riskier assets like shares and towards perceived “safe” assets. This may negatively impact stock market returns, while benefiting government bonds.

Geographically, investors also shift their money away from the perceived riskier regions such as emerging markets and towards developed markets like the US.

How does this impact portfolios?

We looked at five different periods of heightened geopolitical risk since 1985. To do this we used the Geopolitical Risk Index (GPR), which reflects automated text search results of the electronic archives of 11 national and international newspapers. It captures the number of mentions of key words such as “military tensions”, “wars” and “terrorist threats”.

Periods of geopolitical risk was defined as whenever that index went above the 100 mark, shown below.

We then created a “safe” and a “risky” investment portfolio and compared their performances during these periods¹. We use the term “safe” merely to distinguish between the relative stability of assets like US government bonds versus shares, which are relatively “risky”. We could equally have called them “less volatile” and “more volatile” portfolios.

Our analysis showed that in the short-term the portfolio of “safe” assets delivered higher returns than the risky portfolio in three out of the five periods considered.

We also looked at how a diversified “60/40” portfolio (60% risky assets and 40% “safe” assets) compared. We found that it performed worse than the “safe” portfolio (both in total returns and risk-adjusted).

What if you extend the period until after the geopolitical risk subsides?

The results were particularly interesting when our economists extended their analysis to six months after the GPR index falls back below 100. This enabled them to get a better idea of how an investor would have performed if they had held onto their risky portfolio through the turbulence and then allowed markets to recover.

They found that over the extended period the risky portfolio outperformed the safe portfolio in four of the five periods and scored better than the safe portfolio in risk-adjusted terms in each of these periods.

However, an investor would have had to withstand considerable volatility to realise the benefits of the risky portfolio so we threw into the mix a “dynamic” portfolio. This would involve an investor implementing a safe portfolio as soon as tensions start to rise (the GPR goes above 100) and switching to the risky portfolio when they dissipate (goes back under 100).

For an individual investor this would likely not be practical with their own portfolios. However, it’s likely the best option for those who entrust an active fund manager that takes geopolitical risk into account.

This dynamic portfolio did well, delivering a higher return (both total and risk-adjusted) than the risky portfolio in three out of the five periods and higher than the safe portfolio in four out of the five periods. The analysis showed that active fund managers can potentially avoid some of the losses and still enjoy much of the benefits from taking geopolitical risk into account.

Commenting on the findings, Schroders Global Chief Economist Keith Wade said, “There has been a significant increase in geopolitical risk during the Trump presidency. The emergence of China as a global superpower and the rise of populism means this is unlikely to change soon. We have seen this in the recent breakdown of talks between the US and China: tensions between the two nations remain high and the GPR index remains elevated.

“It is also the case that the scope for central banks to ease monetary policy and provide support to markets as an offset to heightened political risk is less than in previous episodes, given the low level of interest rates and size of central bank balance sheets. Consequently, taking geopolitical risk into account when choosing portfolio strategy will be increasingly important for investors.”

¹ The safe portfolio allocates 50% to the US 10-year benchmark government bond, with the rest equally distributed among gold, Swiss franc and Japanese yen. The risky portfolio comprises 50% in the S&P 500, the rest allocated evenly between the MSCI World and MSCI EM Equity indices. After 2007 we also include a basket of local EM sovereign debt made up of local currency sovereign bonds of Turkey, Brazil, Mexico, Russia and South Africa.