As we are seeing at the start of 2022, with the conflict over Ukraine, such crises can cause considerable market volatility. But what makes a political crisis a concern to investors, how can it impact markets, and what can you do to help protect your portfolio?
Overall, political and geopolitical risks could weaken economic activity, reduce investment returns, and lead to a flight from riskier assets. But they are important to put in context. Even when crises impact major nations and threaten key resources or trade, these effects tend to be short-lived. Since the attack on Pearl Harbor in 1941, the S&P 500 has been higher three-quarters of the time 12 months after the start of a crisis. Half the time, markets have only taken a month to recover, based on an analysis by Truist based on FactSet data.
It is worth noting that US equities have risen about seven of every 10 years since World War II, so fortune typically favors the cool-headed. This also supports the argument that geopolitical crises seldom cause global economic downturns, with the Arab oil embargo being a notable exception.
In addition, most political crises that could potentially cause significant damage end with a diplomatic solution, or become chronic, rather than acute, disputes that only occasionally grab the headlines when tensions flare. North Korea’s strained relations with the US, which flared up in 2017, provide an example of a crisis that rumbles on for years without—at least so far—escalating into a full-scale conflict.
How can investors help defend themselves from geopolitical risks?
Unfortunately for investors, there is no one-size-fits-all hedge. The perfect hedge would depend on the nature of the crisis, which is impossible to predict. Even so, investors can apply these general principles:
1. Diversify geographically. Most geopolitical crises will impact some nations more than others. Since you cannot anticipate where the flare-up will happen, maintaining a geographically diverse portfolio is the best basic hedge.
2. Consider some exposure to “safe haven” assets. These can include gold, Swiss francs, US dollars, Japanese yen, US Treasuries, low-beta stocks, and select hedge fund strategies. However, this is not a static category. A selection of defensive investments—diversified in their own right—can help reduce volatility.
3. Explore hedges that have upside potential even if the crisis does not escalate. The best hedge is one that you expect to rise in value over the long term even if the geopolitical crisis is resolved, but would outperform if the crisis escalates.
4. Keep a long-term focus. Geopolitical risks seldom have more than a fleeting impact. So try to avoid being caught up in the panic-thinking, and do not sell into the crisis. In addition, there is almost never a time when there is no potentially significant political crisis on the horizon, so put them in perspective.
5. Build a “buffer” against volatility. When it comes to managing risk in your portfolio—whether it comes from a geopolitical shock or from another source—the priority is to make sure that your portfolio is designed so that short-term market volatility does not interrupt your ability to meet your goals.
What does all this mean now?
Geopolitical risks have come back into focus because of the conflict between Russia and NATO over Ukraine. As is often the case with geopolitical crises, events are moving fast, and views can quickly become dated. However, we have clear views about how investors can best position themselves.
In our latest Global Risk Radar publication, we argued that both sides will ultimately calculate that military conflict comes at too high an economic and political cost to be worthwhile. For Russia, tighter sanctions would damage its long-term growth outlook, and domestic sentiment could sour quickly, as the protests in Belarus in 2020, Russia in early 2021, and Kazakhstan this year illustrate. The European Union would also suffer sizable consequences, given that Russian energy accounts for nearly 40% of its gas imports and 30% of its oil imports. As for the US, the European security situation is drawing attention away from President Joe Biden’s plans to reinvigorate the American economy against a backdrop of sliding approval ratings and already high energy prices.
Against this backdrop, our advice to investors is:
1. Diversify and keep a long-term view. It is important to remember that equity market declines driven by geopolitical stress events are typically short-lived.
2. Consider geopolitical hedges, including commodities. This is relevant for investors who are worried about an escalation scenario. We note that when geopolitical events are accompanied by a supply-driven oil price shock, markets have historically tended to see larger losses and taken slightly longer to recover. This makes allocations to commodities and energy stocks an attractive option, in our view, to help investors hedge portfolio risks.
3. Buy the winners from global growth. Despite recent volatility, it is important to remember that we are still in an environment of robust economic and earnings growth, and in our base case we expect upside for equity markets over the balance of the year.
Main contributors: Christopher Swann, Dirk Effenberger, Daniil Bargman, Dominique Huber, Justin Waring
Content is a product of the Chief Investment Office (CIO).
See the full report – CIO tutorial: How can investors deal with political risk?, 17 February, 2022.
