Geopolitical risk is “no. 1” concern for investors
Geopolitical issues are an ever-lurking danger to investor wealth but with a trigger-happy president in charge of the world's biggest economy, seemingly hell-bent on upsetting existing trade and political relations, the risks have rarely been as rife in the post-World War II era as they are now.
So it is hardly surprising that investors, and sophisticated ones at that, are increasingly seeking out specialist guidance on how best to deal with the growing geopolitical challenges.
"This is the number one question we’ve heard from [investor] clients in past 12 months,” Elliot Hentov, head of research at State Street Global Investors's official institutions group, told AsianInvestor. “Do I do nothing? Do I reposition? How do I learn from history?”
The feedback is that these queries are coming from asset owners across the board, not just from sovereign entities.
“Geopolitical risk is playing a much bigger role [in investment decision-making] than it did in the past,” Hugh O’Reilly, chief executive of OPTrust, Canadian state pension fund with C$20 billion ($15.4 billion), told AsianInvestor.
For O’Reilly, it's not just the about impact of trade tariffs on the wider market environment as US President Donald Trump ups the protectionist ante, but also about the emergence of more populist tendencies in countries ranging from Italy to Sweden and the UK.
“All of these things have potential to play a role [in portfolio construction],” he said.
In response to the growing wall of investor queries, State Street Global Investors last month published research showing how financial markets react to geopolitical factors. It looked at how 71 events between 1986 and 2018 – both ‘positive’ and ‘negative’ ones – had affected the returns and volatility of different currencies and equities.
The events covered included the Oslo Accords in Israel in 1994 (positive), the 9/11 World Trade Center attacks in 2001 (negative), the European Union announcing accession talks with Turkey in late 2004 (positive), and the 2008 Mumbai terror attacks (negative).
The SSGA study underlined that emerging economies are particularly vulnerable when geopolitical factors strike.
It identified four emerging market countries that are highly exposed geopolitically and have relatively deep and liquid financial markets: India, Israel, South Korea and Turkey. These are the only nations that fit all the criteria the fund house had set for use in the study.
PORTFOLIO IMPLICATIONS
“Most of the conclusions have clear implications for tactical positioning,” said London-based Hentov, especially for investors with heavy exposure to emerging markets.
For those without a tactical portfolio, he said, the research suggests they can take a more strategic view of a potential event and the market fundamentals, to decide if it’s worth putting in place any hedges. Many official institutions have a deep bench of talent, added Hentov, which would enable them to integrate such thinking into their processes.
For one thing, the main impact of a geopolitical event generally takes place in a period of just over a month from when it happens. Hence it is that period that sees the biggest outperformance versus historical returns after positive events, and the greatest underperformance after negative events, Hentov noted.There is a wide dispersion between the results of the four nations assessed, but there are several key broad findings.
That said, after negative events, indices take far longer to recover in foreign-currency terms, as the differences in volatility persist for longer, the report shows. On a currency-adjusted basis (that is, with MSCI local indices converted to US dollars), stock markets nearly ‘shrug off’ negative events within a year, while positive ones still reverberate, even over that time horizon (see figure below).
In addition, the SSGA report finds, there appears to be a sweet spot for dollar-based equity investors around one month after positive geopolitical events. This is down to the combined effects of currency and equity outperformance outweighing a modest rise in volatility.
The research also noted specific differences in the way currencies and equities behave.
Currency spot markets often react instantly to negative events, losing as much value in two days, on average, as they normally do over a month. Stocks react to positive and negative events in a more symmetrical fashion: after an event, rolling returns stay above or below the historical average for one to two months.
Hentov cited the current US-China trade dispute as a practical way of applying SSGA’s findings. “If there was a real resolution of the standoff, the renminbi would appreciate quite substantially in the first hours or days,” he said, “and would give a boost to the Chinese stock market.”