Global disorder: what does geopolitical risk mean for investors?
Global stock markets remain close to record highs, despite the escalating conflict in the Middle East. Over the longer-term, geopolitical shocks have had limited impact on global markets. However, they can be a source of significant volatility in the short- and even medium-term.
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If anyone had told you a decade ago that we’d have war in Europe and the Middle East and the Republican candidate for the US presidency threatening to withdraw from NATO, you might not have expected it to be accompanied by record highs in equity markets. But that is essentially the situation we have today. In our conversations with clients, we know that geopolitical risk is a concern for many of you. How can markets just sail on amidst so much conflict?
The question has become even more pertinent following the latest hostilities between Israel and Iran. At the start of October, Iran fired almost 200 missiles at Israel. Israel has said that it will retaliate and the risk of wider conflict is high.
So far, the market reaction has been muted. When Iran and Israel clashed in April, stocks experienced their worst week in a year. In October, they barely fell by 1%. Brent oil prices have jumped by around $5 to $74 per barrel this time around but remain some $10 per barrel below the highs of the year.
Investors appear to be taking the view that recent developments will not derail economic activity or corporate profits. This could be somewhat optimistic.
Over the longer term, global equities have delivered impressive returns, despite wars and other geopolitical shocks along the way (see the chart below). However, in the short term, geopolitical developments can cause significant volatility, and we are very mindful of the risks. 2022 was a clear example of the impact that they can have. Following the invasion of Ukraine, commodity prices surged, contributing to the sharp rise in inflation and significant losses in both stock and bond markets.
Global equities have delivered impressive returns, despite geopolitical shocks along the way
Value of $1,000 invested in the MSCI World Index with dividends reinvested
Source: Cazenove Capital, LSEG Datastream. Past performance is not a guide to the future and may not be repeated.
As long-term investors, we believe it is important to remain invested through periods of uncertainty. However, we recognise that high levels of volatility may may not be consistent with a client’s risk appetite. Geopolitical developments can also create shorter-term risks and opportunities that we want to avoid or take advantage of. We have a number of tools at our disposal to do this.
Getting the right asset allocation
Our ability to allocate capital between different asset classes, and different regions of the world, is key to how we manage geopolitical risk within portfolios.
In our multi-asset portfolios, we will always hold a mix of defensive and diversifying assets that protect portfolios from shocks – whether economic or geopolitical. This will generally include government bonds, which tend to act as “safe havens” when investors are anxious. However, as we have seen over the past few years, bonds are not always the most effective form of protection when inflation is high. And higher inflation is often one consequence of war and conflict, which can disrupt trade routes and commodity supplies. As a result, when we are concerned about geopolitical risk, we are also likely to have meaningful exposure to gold and other commodities. We currently hold both. Gold has been one of the best performing major asset classes of the year (up 27.5% to the end of September). The performance of other commodities has been mixed, but we believe they remain an important diversifying holding.
We can also move quickly to adjust our asset allocation in response to geopolitical developments. Following the invasion of Ukraine, we reduced our exposure to equities as the threat of “stagflation” (rising inflation and low or negative growth) increased. Within our remaining equity allocation, we cut our exposure to Europe, which we judged to be at greater economic risk from energy shortages. Both decisions helped performance in a difficult year.
Currencies are another tool that help us manage the impact of conflict. Portfolios have significant exposure to the US dollar and Japanese yen, both of which can act as safe havens during periods of heightened volatility. This provides portfolios with some in-built protection.
Scenario planning
Understanding what different scenarios could mean for the economy and markets is perhaps the most important part of our approach to geopolitical risk. Our investment committee meets on a weekly basis and reviews high risk situations regularly. The committee can and does come together at very short notice to take decisions in response to significant market-moving developments.
A key input in our scenario planning work is analysis from Schroders’ economists. The team looks at a wide range of scenarios for the global economy, including geopolitical shocks. One scenario that they have recently modelled is a Middle Eastern war, with oil prices spiking towards $150 per barrel and key shipping lanes closed. The macroeconomic impact is likely to be highly “stagflationary”, with inflation rising and global growth slowing, as was the case following the invasion of Ukraine.
War and conflict can have very negative consequences for individual countries and even the global economy. At the same time. history suggests that positioning for the worst case is costly over the long term. A pragmatic and active approach is essential to getting the balance right.
Exploring the transmission mechanisms |
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Recent years have unfortunately illustrated some of the ways in which adverse geopolitical developments can impact the global economy. They tend to have an inflationary impact and are one aspect of the broader trend of “deglobalisation.” |
Commodities and inflation Energy and food prices soared following the invasion of Ukraine, as exports were obstructed or cut off by sanctions. Higher commodity prices were not the only factor behind the global spike in inflation, but they were a significant contributor. |
Global trade and supply chains Conflict, tariffs and sanctions have forced companies to reassess how and where they source supplies. Many are “onshoring” (bringing production back to their home country) or “friendshoring” (shifting production to a political ally). |
Government debt and spending Recent geopolitical developments have been very costly for governments: the UK spent over £50 billion (2% of GDP) to support businesses and households cope with higher energy costs in the 2022-2023 tax year. Defence spending has been increasing, further straining budgets. |
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