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24/05/2017

CIO Blog: Red Alert?

The world has seemingly been on the brink for months, if not years.

The world has seemingly been on the brink for months, if not years. The all-too-familiar red bannered “breaking news” headlines continue to hit the newswires on a near daily basis, making it impossible to avoid the unfolding geopolitical tensions or to react viscerally. Seared into the collective investment conscious have been the Brexit referendum and the election of Donald Trump in 2016. Numerous other geopolitical events have threatened to spill over into an economic recovery that is fragile, but finally gaining genuine global traction. So far in 2017, elections in the Netherlands and France, a referendum in Turkey and sabre-rattling across the Korean Peninsula have all threatened to derail markets at one time or another.

Looking back further over the last ten years – from horrific terror attacks to disputed annexations of gargantuan swathes of territory – geopolitical flashpoints have generated huge amounts of human pain, suffering and anguish.

But what impact do they have on risk assets? Should investors adjust their portfolios when those red alerts hit their screens, or should they stick to their investment processes by focusing on fundamentals?

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 simply 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. 

Investment implications

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; upcoming election in Germany and Italy are just two of a number of imbroglios. While they will undoubtedly cause jitters 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.

Medium and long term performance is driven by fundamentals rather than geopolitical headlines. Market fundamentals such as equity valuations which are increasingly expensive, but not alarming, 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 some admittedly are flashing amber.

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