Investing In A Disorderly World

Investment returns are driven largely by factors that can be quantified and evaluated — economic growth, monetary policy, business investment and, of course, corporate earnings. More difficult to parse are the impacts on investment performance from geopolitical developments — military conflicts, terrorism or an unexpected election result. These geopolitical or “headline” events can upend financial markets and generate significant losses for investors. In the discussion below, Joseph Quinlan, Head of CIO Market Strategy, provides his perspective on the impact of geopolitical events on global financial markets and on the strategies investors might employ to manage geopolitical risk.

How do you Define Geopolitical Risk as it Applies to the Investment Realm?

Geopolitical risk, to put it simply, is the risk that a geopolitical event — anything from a major terrorist attack to an unexpected election result in Europe — triggers a fundamental shift in asset prices. The vote in Britain to leave the European Union or Russia’s annexation of Crimea are two recent examples of a geopolitical event. Some events are absorbed pretty easily by the markets; others can trigger a market rout, at least in the short term. The impact on asset prices varies with the event. The fallout is most severe if the event is perceived as altering the existing political and economic order, which, in turn, could impact economic growth, corporate earnings, asset prices and investor behavior.

So a Change in the Status Quo generates Anxiety, Which Causes Investors to Rethink their Assumptions and Liquidate Assets?

Well, it depends on the nature of the geopolitical event and where it occurs. Not all geopolitical events have the same impact. For example, as significant as it was from a geopolitical standpoint, Russia’s move into the Crimea and eastern Ukraine didn’t have a significant impact on markets in the United States. The impact was greater on German equities because German companies export a lot of products to Russia, and the imposition of sanctions on Russia put a drag on German-Russian trade. But even in Germany, Russia’s adventurism didn’t rout the financial markets. Brexit, on the other hand, upended financial markets globally because it weakened the European Union by raising the prospects of the disintegration of the EU. Even with Brexit, however, the global financial markets bounced back fairly quickly. And that tends to happen quite often with geopolitical events. The markets react strongly and then quickly revert to business as usual. A major geopolitical event can become a nonevent very quickly.

Why does the Sentiment Change So Quickly? Do Investors have a Short Attention Span, or is it that they are more Optimistic than we might Assume?

I think optimism actually plays a part in it. Since World War II, we’ve been blessed with peace and prosperity. We’ve had regional conflicts that have been costly in terms of blood and treasure — wars in the Middle East being a prime example — but we haven’t seen any global conflagrations that have set humanity back for decades. Europe has been peaceful for 75 years; China’s rise has been peaceful; the Soviet Union collapsed under its own weight, not from war. This postwar stability has supported strong global growth. Per capita income has grown significantly not only in the developed countries, but also in the emerging markets.

So I think the behavior of the financial markets after a crisis reflects an innate confidence that things will work out because they generally have for several generations now. This is due in large part to the institutions established after World War II — the United Nations, NATO and the International Monetary Fund — that have headed off crises or helped restore equilibrium after one. Pessimists might argue that this confidence in the future is more about complacency than optimism, but whatever the reason, the markets have tended to bounce back pretty quickly from even major geopolitical upheavals.

Have Globalization and the Greater Connectivity among the World’s Economies Magnified the Impact of Geopolitical Events or Helped to Mitigate the Damage from them?

I think globalization widens the area of impact from a geopolitical disturbance, but it can also help prevent a crisis from intensifying. To the latter point, trade and commerce among nations promotes peace because it gives them a vested interest in maintaining stability. A journalist once said that whenever two countries have McDonald’s, they don’t go to war. That’s taking the point way too far, but it is true that global trade creates linkages among nations that incentivize them to maintain the status quo. Exports and imports generate significant economic activity, income and jobs, so it’s in no one’s best interest to create conflicts with your trading partners. You don’t want to wage war on the Golden Goose. That said, globalization sometimes does exacerbate crises, the 2008 financial crisis being a good example. The connections among global financial institutions allowed problems at a few U.S. institutions to spread around the world. Generally though, globalization is a close associate of peace, which has been good for investors.

Are there Any Events or Issues on The Horizon that you Believe Could Undermine Investors’ Optimism or Snap them out of Their Complacency?

There are some threats that, if realized, could generate a significant and long-term decline in asset prices. An obvious one is a nuclear conflict with North Korea. We have to hope that China will not allow the situation with North Korea to deteriorate. Certainly China has a strong interest in maintaining stability in the region. Another more probable and more worrisome scenario is a major cyberattack on the U.S. electric grid. The grid is vulnerable, and if it or a large section of it were to go dark for weeks, that would be disastrous. People wouldn’t have access to their bank accounts; they couldn’t travel or conduct business. The damage would extend beyond the immediate economic losses. That kind of attack would sow the kind of chaos that scars psyches and potentially alters behavior even after power is restored. Needless to say, there would be a significant plunge in asset prices, which could take a long time to recover.

Are there Long-Term Trends that you believe could be Problematic for Investors?

Rising populism is somewhat worrying in that it could lead to a loss of support for the norms and institutions that support the liberal political and economic order. We’ve already seen a decline in support for open borders in Europe and for multilateral trade agreements like NAFTA. If the trend continues, there is greater potential for truly disruptive geopolitical developments like the disintegration of the European Union, although that doesn’t seem as likely as it did a few years ago even with the Brexit vote. The greatest risk is advances by fringe political parties that undercut traditional democratic values like religious tolerance and belief in the rule of law. The good news is that historically, democratic societies have responded to social discontent before it posed a dire threat to their way of life. Positive change can come even to autocratic societies; witness women now being allowed to drive in Saudi Arabia. So there’s reason for concern, but also reason for hope.

So Given the Geopolitical Risks Confronting us today, what do you Tell Clients Who Ask for Guidance on Mitigating the Impact of Geopolitical Events on Their Investment Portfolios?

Well, the first thing we tell them is not to overreact to any given event or crisis because, as I mentioned, the markets often have bounced back from even major geopolitical developments, whether it’s 9-11 or Brexit. So you don’t want to disrupt your investment strategy because of an event that might only have a short-term impact. That said, geopolitical events can be disruptive, so investors need to account for geopolitical risk just as they account for equity risk, credit risk, currency risk, etc. It needs to be part of their risk management effort. The challenge with geopolitical risk, of course, is that you often can’t foresee the event, let alone calculate its probability or assess its long-term ramifications. This is especially true at a time when you have non-state actors like ISIS, or rogue states whose actions are driven more by ideology than by reason.

So given those Realities, How do you Manage Geopolitical Risk?

You don’t focus on managing geopolitical risk specifically, but you factor that risk into an investor’s overall risk management framework. Diversification is the cornerstone of risk management, and it can be employed to address geopolitical risk just as it can be to manage equity risk, liquidity risk or any other type of investment risk. For example, you might not be able to anticipate a given geopolitical crisis, but you can reasonably assume it will trigger a flight to quality, so you should consider a healthy allocation to investment-grade bonds or relatively safe-haven assets like U.S. Treasurys and precious metals. With equities, you might maintain exposure to defensive sectors, such as utilities or consumer staples. Defense stocks may also make sense if conflicts arise or intensify.

What about Hard Assets?

Gold and other precious metals can serve as a useful hedge, as can other strong currencies, such as the yen or the Swiss franc. Even better, I think, are assets like commercial or residential real estate and timberland or farmland. Assets like those can offer excellent diversification benefits because of their low correlations with financial assets like stocks or bonds. They also offer income. People tend to pay their rent no matter the global crisis du jour. And they need to eat and build houses, so the value of land for farming and lumber remains relatively stable. Most important, since relatively few people hold farmland or timberland, you don’t tend to see their value plummet in a crisis, which can happen with equities if millions of investors head to the exits in a panic.