Over the past year, geopolitical concerns have weighed heavily on markets. Much of the spike in volatility seen since October of last year has been related to concerns over the US/China trade spat – and the recent market rally appears to have been driven by a softening of rhetoric. These periods are not uncommon. Geopolitics always has the power to disturb investors and derail markets. It will continue to be important in 2019 and beyond, but how can it be managed?
Geopolitical risks are distinct from political risks in that they cross borders, even though the two terms are often used interchangeably. The drivers are usually conflict between countries that typically takes the form of trade tensions (the current situation is not new), populism, oil shocks or military conflicts. Currencies and commodities are usually the first to take the hit from these disputes. Political events can become geopolitical – Brexit is, for the time being, a localised event, but could have repercussions across Europe should a ‘no deal’ scenario arise.
Historically geopolitical risks have been high impact, low probability events that are best ignored unless and until they occur. Over the past 12 months, however, they appear to have increased in importance. The US/China trade war has captured most of the headlines, but there have also been conflicts in the Middle East and concerns over the oil price. There have been problems across Europe as populism becomes an increasingly urgent and divisive force.
Understanding the impact
Our research shows that the oil shocks of the 1970s had major impacts on economies and global stock markets. The first oil shock was when OPEC members decided to embargo oil in 1973 for a six month period. In the US, annual consumer price inflation nearly doubled to 11% in 1974 and the economy contracted that year, after growing by 5.6% in 1973. Over in the UK, energy-driven consumer price inflation peaked at over 26% in the summer of 1975, the economy spilled into a recession and the British government was forced to seek a loan from the IMF. The Iranian revolution in 1979 prompted another oil shock, with US inflation peaking at 13% in 1980 and tipping the US economy into another recession. Both oil shocks led to sharp declines in global stock markets. While there are reasons that the impact would not be as significant today – notably the growth of shale gas in the US and Canada, increased Russian crude oil production and the growing use of alternative energy – this is an important area to watch.
Non-oil geopolitical events have not had the same impact. In general, the impacts have been short-lived and unpredictable. This includes major events, such as the Vietnamese, Bosnian and Afghanistan wars, Tiananmen Square, Russia’s annexation of Crimea and the Arab Spring.
Political events can have an effect on the relative performance of individual markets. The most obvious example of this today is the UK and Brexit/Corbyn. UK assets have been out of favour with global investors, as fund managers have worried about the dent to the UK economy from Brexit and the prospects for a left-wing Jeremy Corbyn Labour government. Recently, Labour’s support has waned and breakaway Labour MPs are likely to draw voters away, but UK assets have yet to recover.
What can protect against geopolitical tension?
Gold has long been the go-to asset to protect against geopolitical unrest. However, our research suggests that while gold will often rally as geopolitical problems mount, it does little when markets are in the thick of geopolitical political problems. A more effective hedge has been US equities. Even when the US has been the epicentre of geopolitical problems, as it is today, it has proved defensive. This is largely because US companies have returned more to shareholders through share buybacks and have generated superior earnings when compared to their global peers. As a result, US financial assets can be seen as a relative safe haven in times of stress.
Where are the most significant geopolitical risks today? We are watching the situation in Saudi Arabia closely and relationship between Riyadh and Washington. The US government seems to want to keep the crude oil price in a $50-80/barrel range and the Saudis have been happy to oblige by increasing or decreasing production when the range is threatened. That’s probably because the Trump administration has given near unconditional backing to the Saudi government, even after the Khashoggi affair, where a Saudi journalist was murdered in the Saudi Arabian embassy in Turkey. This gives Saudi decision makers more confidence, potentially accelerating their aggressive moves into neighbouring territory. This could cause heightened conflict in the Middle East, which may influence oil prices.
Also threatening oil prices is the situation in Venezuela, which is currently a ‘proxy war’ between the world’s superpowers. The US and the bulk of Latin America support Juan Guiado, who declared himself interim president on 23rd January, while Russia, China and Cuba support the incumbent Nicolas Maduro. The problem, once again, is oil.
The US/China trade problems go far beyond tariffs and extend to a rebalancing of power across the world. First, the introduction of the petro-Yuan reduces the role of the US$ in global oil markets. And second, China’s Made in 2025 policy to upgrade the technological sophistication of its manufacturing base is seen as a direct threat to the US, the world’s tech leader. A key battleground is over the supremacy of 5G telecommunications, a vital enabler technology to handle the explosive growth in global data generation from the Internet of Things (devices that can communicate and interact with others over the internet, such as smart traffic control sensors).
We also have our eye on European populism. This has been growing in line with lack lustre growth and income inequality, which in turn has been driven by technological progress and globalisation. Austerity has meant that governments have not had the fiscal tools to deal with the problem. This has brought forth a populist government in Italy, riots in France and the rise of the Far Right in Germany. The European parliamentary elections are looming and may be a flash point for conflict.
Any analysis of geopolitical risk needs to come with an evaluation of how much is already priced into markets. Have markets over-reacted to the risk? Our research suggests that if a conflict involves a major oil producer and oil markets are already tight, the event is probably worth hedging (best via US equities, rather than gold). At the same time, it is important to watch domestic political tensions when judging the relative performance of asset markets. Overall, unless geopolitics is going to impact global growth, there are more important things to worry about.