Banking on geopolitical uncertainty
Written by Julien Lafargue, Chief Market Strategist
Please note: The article does not constitute advice or any form of investment recommendation. All numbers quoted were sourced from Bloomberg data as at Monday 31 July 2023. Past performance is never a guarantee of future performance.
On Friday 21 July, Bloomberg Terminal users were welcomed by the flowing quote of the day: “The one unchangeable certainty is that nothing is unchangeable or certain1” – John Fitzgerald Kennedy.
What was true under JFK is still true today and geopolitics is probably the area that feels the most uncertain currently. Whether it’s the war in Ukraine, the 30th consecutive week of mass protests in Israel, the continued tensions between the US and China, the political instability in Spain, or the ongoing military coup in Niger – to name just a few of today’s issues – every corner of the world seems to be subject to some form of (geo)political instability. But what, if any, are the implications for investors?
Better the devil you know
Uncertainty is both the investor’s best friend and worst enemy. It brings attractive opportunities, as well as undesired risk. Domestic investors in Israel, for example, where political and judicial tension has gripped the country for a number of months, are experiencing this first hand.
Since the beginning of the year, the shekel has lost some 4% versus the US dollar, posting some of the worst returns of any major currency. This poor performance is mirrored by the local stock market with the Tel Aviv 35 index trailing global developed equities by 12% over the same time frame. Thankfully, history has shown that geopolitical uncertainty tends to have a limited long-term impact on investments, especially if an investor is patient enough.
Tel Aviv stock exchange 35 Index relative to MSCI World
Take the US as an example. At the time of publication, the S&P 500 index – which tracks the performance of America’s top 500 firms by market capitalisation - has generated total returns of 9.6% per annum since 1928. While history is of course no guarantee of future performance, the index’s track record so far has been despite numerous wars, including World War II, countless financial crises, a series of oil shocks, and a few pandemics.
Of course, individual investors don’t all have a 100 years’ investment time horizon. Yet, between the invasion of Ukraine by Russia in February 2022 – arguably the most significant geopolitical development in recent years – and the end of July 2023, the S&P 500 had managed to return more than 10%.
Tellingly, this recent performance has happened against a backdrop of significant geopolitical friction between the world’s two largest economies. Having cooled since the Trump-inspired trade wars, US-China relations took a turn for the worse earlier this year when an alleged spy-balloon flew into US airspace. It was a classic example of short-term (negative) political noise distracting, or masking, the longer-term (positive) investor reality.
S&P Index (log scale)
Diversification is key
None of the above is to say that investors should simply ignore geopolitical risk, especially if their time horizon is in years rather than centuries. Like any other risk, it needs to be assessed, accounted for and managed. Unfortunately, unlike interest risk or recession risk for example, (geo)political risk is extremely hard to handicap and therefore to hedge.
The election of Donald Trump in 2016, or the Brexit vote in the same year, are two recent examples of (geo)political surprises that the market failed to interpret and position appropriately for.
The only tool available to investors to insulate themselves from geopolitical unknowns is very basic: diversification. This is true, of course, at the asset class level with a portfolio that spans beyond stocks and bonds. In fact, one of the main reasons why we might own gold in a portfolio is to provide a safe-haven cushion when it feels that the worst is yet to come.
But, importantly, diversification should also apply to geographies. In a world where tensions are everywhere, it is crucial to spread the risks across regions and to avoid so-called ‘home bias’. As we wrote about earlier in the year, investors can occasionally put too much faith in local assets at the expense of global alternatives. This can lead to a portfolio having a disproportionately large domestic exposure, when in reality, the location of an asset shouldn’t be the primary reason it is chosen (you can read more about that in this article: Overcoming home bias when investing).
The benefit of hindsight
Finally, diversification should also apply to counterparties.
Some investors learned this lesson the hard way earlier in March when a handful of significant financial institutions had to be rescued. Clients of US-based Silicon Valley Bank and First Republic Bank, as well as European giant Credit Suisse, probably thought that their multi-asset class and international portfolios were properly diversifying away any risk. Unfortunately, they had forgotten about counterparty (in this case their own bank) risk.
In sum, diversification really is about not putting all eggs in the same basket. Applied to investments, this metaphor encourages a strategy made up of different portfolios which themselves would be adequately built across various, and ideally uncorrelated, asset classes and held with different institutions around the world.
This wouldn’t guarantee positive absolute returns in the short term, but it would go a long way in reducing risks and allowing compounding to generate attractive returns over the medium and long term.
As an investor, not keeping your assets in enough baskets – which can include favouring your own country too much due to home bias – might come back to bite. On the flip side, staying invested during turbulence, and maintaining a global mindset, are two things that could make a positive long-term difference when short-term political events flare up.
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