3rd September 2014
Kleinwort Benson’s chief investment officer Mouhammed Choukeir asks whether investors should be adjusting their portfolios to cope with global political risks.
He notes that historic crises – even those as dramatic as the Cuban missile crisis – have not necessarily adversely affected market. The 1973 Arab-Israeli war was accompanied by an oil embargo. Now with three crises at least, what should investors expect. We publish the note below.
The stories of human suffering combined with the risks of military escalation have dominated the press – including the financial media. The all-too-familiar red bannered “breaking news” headlines continue to hit the newswires on a daily basis, making it impossible to miss the unfolding geopolitical tensions.
“While regional conflicts inevitably hurt local economies, the key question for investors should be how much do they affect broader financial markets? Should investors adjust their portfolios when those red alerts hit their screens, or should they stick to their investment processes by focusing on fundamentals?”
A number of conflicts
A number of conflicts around the world have made the front pages in recent months, with three key events securing the lion’s share of coverage in the press and social media.
Firstly, the conflict in the Ukraine has put a number of Western powers in direct confrontation with Russia. Severe sanctions are already in place. Germany, which is highly dependent on Russian energy, has seen its equity market sell off by 10 per cent, only to bounce back after tensions eased. European stocks, already burdened with a precarious economic recovery and the spectre of deflation, are particularly vulnerable to the Russia-Ukraine crisis.
Secondly, the Israeli-Palestinian crisis is at full tilt, the worst it has been for decades. Although a ceasefire has been agreed, the risk of renewed tensions remains. Ceasefires have been broken time and time again in the region. The implications of a prolonged Arab-Israeli crisis can be devastating for markets. In the 1970s, conflict in the Middle East led to a surge in oil prices, triggering double digit inflation and a recession that crushed financial assets.
Finally, in Iraq and Syria, the recent rise of the IS (Islamic State) has forced Western powers to intervene to stem the growth of the insurgency in the region. The US and the UK are reluctant to get drawn back into a conflict in Iraq, but they are increasingly under pressure to do something rather than sit by and watch the IS grow in power.
The signals behind the noise
It is easy to draw the conclusion that one’s asset positioning should be defensive during times of heightened conflict or stress. However, financial history teaches a different lesson: geopolitics rarely impact equity markets over the medium to long term. The data just does not support the “geopolitical tensions are bad for markets” hypothesis.
For example, the world was brought to within an inch of nuclear Armageddon during the Cuban missile crisis in October 1962 (markets were reasonably flat in the months leading up to the crisis). An investor in the S&P 500 – a US and global equity bellwether – would have been up 7 per cent in the following month, up 16 per cent over the next quarter and up 34 per cent a year later. Khrushchev may have blinked, but investors were on a roll.
Though investors at the time were indeed relieved that the world did not end, it hardly meant an end to tensions. The Cold War was still very much in full swing, and less than two years later, in August 1964, the US Congress passed the Gulf of Tonkin resolution officially “authorising” the Vietnam War. With the US waging a tremendously costly war across the globe, one would imagine equities performed poorly. Once again, investors were rewarded by staying the course: the S&P 500 returned nearly 9 per cent over the following year.
The experiences above are not isolated. Investing in the S&P at the advent of the Six-Day War in 1967 between Israel and its neighbours would have returned 13 per cent over the next year. Investing when the Soviets invaded Afghanistan in December 1979 would have returned nearly 10 per cent in the next six months, a return that shot up to 30 per cent in the next 12 months. More recently, the invasion of Iraq during the first Gulf War in March 2003 delivered strong returns for investors: the S&P rocketed up by 35 per cent in 12 months. Markets during these crises were not calm by any means; the invasion of Afghanistan saw gold, a defensive asset in times of economic and financial stress, hit its highest ever inflation-adjusted price, well over $2,500 by today’s standards.
Although the above examples show that crises do not always lead to losses, of course, there are examples of when they did. The Arab-Israeli war of 1973 was followed by terrible losses in equities. An Arab oil embargo – brought on by the war – led to crushing inflation. The S&P lost nearly 10 per cent in one month and one year later, the losses were 35 per cent. Another example is the September 11th attacks in the US which saw investors lose 16 per cent over the course of the following year.
But geopolitical crises, for all their horrific images, real-time press coverage and social angst, simply do not appear to affect markets often.
Analysing 16 serious geopolitical crises since 1950, only four saw the S&P down one month later. Similarly, four events saw markets lower over the next six months or the next 12 months. Of the 25 per cent of times where the market did turn down, the factors were often not entirely geopolitical (if at all). During the Arab-Israeli War of 1973, the oil embargo was indeed a main cause of inflation. However, the Bretton Woods system (an international monetary order that fixed exchange rates that had been in place since 1944) had only recently collapsed. Additionally, following September 11th, equity markets lost value, but arguably the boom and bust of the nascent tech sector was a core driver of those losses.
Geopolitical tensions are likely to continue dominating the headlines in the coming months. While they will undoubtedly create jitters in markets in the short run, their impact on medium and longer term performance is likely to be minimal. Unless of course, those conflicts significantly change the course of market fundamentals. For example, a huge surge in the price of oil that sparks a run of high inflation would be damaging. For now, this risk is currently low. In fact, the price of oil is down 5 per cent so far this year even with all the geopolitical tensions in energy sensitive regions. The supply shortage in affected regions has been offset by increased production from elsewhere.
Medium and long term performance is driven by fundamentals rather than geopolitical headlines. Market fundamentals such as valuations and continued strong positive momentum point towards further gains in equities, thereby supporting our “risk on” stance. We will change our view when the conditions warrant a change: if momentum were to turn negative, if valuations become overly extended, and/or sentiment became overly bullish. For now, none of these conditions are on red alert, though they are flashing amber, hence our reduction to risk since the beginning of the year.