How investors should respond to geopolitical tensions
Just days into 2020, investors were confronted with a fresh escalation: the prospects of war between the US and Iran.
Global financial markets had been jittery after the US ordered the assassination of top Iranian commander General Soleimani on January 3.
Iran also recently admitted for the first time that the Ukraine International Airlines passenger jet that came down last week shortly after taking off from Tehran had not crashed due to technical failure, as previously stated, but rather mistakenly shot down by Iran’s air defence system.
Tensions have been racheting up between the Islamic republic and the US since years, but global markets have seemed more nervous this time than any other.
The tensions have caught investors’ attention mainly because the impact the tensions may have on oil supply in the Strait of Hormuz.
The Strait of Hormuz, located between Oman and Iran, is one of the world’s most important sources of oil supply.
Investors often panic during times of geopolitical noise.
But is this time different?
Should investors dump equities, avoid oil-dependent companies and buy bonds, or take no action at all?
Multi-assets best way to hedge against Middle East geopolitical risks
The poll asked advisers the following question: “What type of global fund is safest in light of Middle East tensions?”
Almost one in two (47 per cent) said investing in multi-asset funds was the best approach to hedge against geopolitical risks.
Another 41 per cent said investing in various exchange traded funds could reduce risks, so long as the ETF contains a diverse range of asset classes.
No adviser thought investing in futures would reduce risks, while about 11 per cent recommended investing in mutual funds as a way to protect their exposure from market volatility
Global markets have faced a high degree of turmoil in the past few days after the US killed Iranian commander General Soleimani on January 3.
On Saturday (January 11) Iran conceded that it shot down the Ukranian International Airlines passenger that came down last week shortly after take-off from Tehran, defying initial claims that the flight came down due to technical failure.
Global crude, a key commodity and indicator of economic health may also be affected due to ongoing tensions, as much of the world’s oil supply goes through the Strait of Hormuz, and growing tensions could lead to lower supply and higher prices, prompting concerns on how investors can protect portfolios.
Matthieu Guignard, global head of product development and capital markets at Amundi ETF, Indexing and Smart Beta, said: "In a context characterised by high geopolitical risk, allocating defensively could help reduce portfolio volatility.”
He explained investors could opt for ETFs to add some factor exposure to their equity allocation, by selecting the most defensive factors such as Min Volatility or Quality, that can help reduce the impact of market volatility on portfolio performance.
Mr Guignard added: “In fixed income they can turn to short maturities and US Treasuries or, if they fear some inflation risk due to a potential rise in oil prices, they could decide to select floating rate notes ETFs.”
Sanjiv Shah, chief investment officer at Sun Global Investments explained multi-asset funds are useful in mitigating risks because they usually tend to have exposure to 2-4 asset classes.
"The Middle East tensions may cause equities to fall but in a balanced [multi-asset] fund bonds may go up especially if there is exposure to commodities.”
How markets should react to geopolitics
Geo-political disputes such as the present tension between Iran and the US can develop unexpectedly, and almost anywhere on earth, but the immediate impact on markets is far more predictable.
As soon as political noise wafts through markets, government bond yields fall, while the price of gold, and gold miners shares, rise sharply, as does the oil price.
Bond yields fall as the price rises, with investors responding to the heightened risk by placing cash into the lowest risk asset, which is government debt.
Gold tends to rise in value at times of geo-political stress because it is scarce, and so holds its value.
Oil prices rise as investors take the view that geo-political uncertainty could restrict the capacity for oil to reach the market, causing prices to rise.
Chris Darbyshire, chief investment officer at Walker Crips said: “ The reality is that an investor can’t really prepare for these sort of specific events, by their very nature.
“But if an investor felt hat geo-political uncertainty would be a particular feature of the year ahead, the thing to do would be to have fewer investments that are cyclical.
“This means less in smaller companies funds and high yield corporate bonds, and less invested in companies that rely on consumer spending for their income, this is because if the oil price rises, then consumers will have less cash to spend on other things.”
Giles Parkinson, who runs the Global Endurance fund at Aviva Investors, noted that if investors are stocking up on gold miners and oil shares, they are selling companies, such as airlines, that consume a lot of oil.
Mr Darbyshire added: “In the event of a geopolitical event, it is also likely that the value of sterling would fall, so if an investor wanted to have some gold in their portfolio as a way to protect against uncertainty, then one could do this by buying a gold Exchange Traded Fund (ETF) product, that hedges sterling, so that one is not investing in sterling.
Because for a sterling investor, in a non-currency hedged ETF, if geopolitics causes the value of sterling to fall, that would wipe out any gains made from the value of the gold rising," he added.
In terms of attempting to insulate a portfolio from political risk, David Scott an adviser at Andrews Gwynne in Leeds, said: “Geo-political risk should just be viewed as part of the mix of things that could cause equity markets to fall.
“So the starting point should be valuations, if the political risk happens at a time when equities are expensive, then the potential for losses to the investor are greater, but really that is just part of portfolio construction, to assess the risk of buying an asset, look at the valuation.
“We would have relatively few equities right now due to valuations, and as geo-politics can be one of the things that causes expensive valuations to fall, heightened geo-political uncertainty for us means safety first.
“And that means increasing exposure to gold, which we have quite a bit of in client portfolios right now.”
Andrew Cole, multi-asset investor at Pictet, said: “Generally speaking, geo-political events have only a very short-term impact on markets, but during those periods, it is likely that the valuations of some risk assets will fall, and that could be a buying opportunity.”
Simon Evan-Cook, multi-asset fund manager at Premier Miton: “Geo-political events are always worrying, particularly as any one of them could spiral into something much larger and more sinister.
“However, as investors we need to remember that there will always be a geo-political event going on somewhere.
Geo-political events are always worrying, particularly as any one of them could spiral into something much larger and more sinister.
“If you had held off investing because of them over the last fifty years you would have missed out on the tremendous returns that equity investors have earned over that time.
“The day that the Iraq war began in 2003, for example, proved an incredibly good time to invest, as it marked the end of the previous bear market and the start of four years of almost uninterrupted rising share prices.
“We take great care to make sure the fund is as diversified as is reasonably possible, including; by individual security, by country; by region; by currency; by market capitalisation and by investment style.
“This means being prepared to ignore indices which, in the case of the global equity index, place most of your capital into US equities and large-cap equities.”
Quite often an event such as military action leads to stock market gains because wars cost money, and the increased spending boosts the economy.
In addition, politicians are more likely to pursue policies that increase spending in the immediate aftermath of a military conflict as a way to keep voters happy.
Within equity markets, Mark Whitehead, who runs the Securities Trust of Scotland investment trust, a global equity fund, said: “One of the likely impacts of geo-politics on markets is that emerging market equities would likely fall.
“This is partly because many emerging market economies are importers of oil, so the higher oil price hurts them, but also because in that sort of environment, investors will want to take less risk, and so will sell off the riskier parts of their portfolio.”
Mr Cole said it is likely that the US dollar would rise sharply in value during periods of geo-political uncertainty.
This is typically bad for emerging market assets, as most emerging market countries and companies have to borrow in the US currency, so a rise in the value of the dollar increases the repayment costs and leaves less cash for re-investment, wages or distribution to shareholders, reducing the returns available from owning the shares.
Alex Harvey, portfolio manager at Momentum Global Investment Management, said the recent tensions in the Middle East had not harmed global equity markets, which have hit record highs since then, but said the impact does tend to be felt in individual markets.
He noted the UK market is particularly exposed to conflicts in the gulf because of the number of oil companies listed on the UK stock market.
He said the best way to avoid being particularly exposed to geo-political risk is to invest in global funds, so that the risks are diversified.
Charlie Morris, head of multi-asset at Atlantic House fund management, said there are few truly surprising geo-political events, and that markets are usually adjusting to geo-political risks slowly as news emerges, but then rapidly shift when the events happen.
Ritu Vohora, investment director at M&G said these rapid market movements when the news headlines are dominated by geo-politics are a “knee-jerk reaction”, with sharp price movements that subsequently reverse, leaving the investor who tried to follow such trends no better off.
Simon Edelsten, who runs the Artemis Global Select fund and the Mid Wynd investment trust, said: “You may think that you cannot do anything about unknown events and perhaps you cannot.
“However we think that having a well diversified portfolio with no investment much larger than another builds in resilience.
“This is why we run a 60-75 stock portfolio compared to some peers concentrating in just 25-30 stocks.
“We believe the broader spread and greater diversity protects capital better when unexpected turbulence appears.
“Indeed it seems hubristic that some managers claim they will generally anticipate and cope with the unexpected.”
At Artemis the fund managers run “stress tests” where the try to model the impact of certain geo-political events, including a much higher oil price, and much higher inflation, in order to ensure the funds they run are not overly exposed to any one scenario.”
Impact on funds
Tom Sparke is an investment director at GDIM, a discretionary fund management firm in Cambridge, a role which involves him selecting funds.
He said the main criteria he looks for in funds at times of heightened political risk are those with a track record of performing well when political uncertainty is at its height.
Mr Sparke said: “The main considerations would be the fund’s performance in a similar environment in the past, it’s downside participation and its sector biases.
“All of these factors would contribute to our decision on the fund but some may take precedence, depending on the nature of the event.
“In the recent increase in tensions with the US and Iran, we considered our exposure to oil, to defence stocks and to more conventional ‘defensives’, such as healthcare and consumer staples.
“We tend to maintain a more defensive stance in most markets within our range of models as we believe this leads to outperformance over the long-term.”
Darius McDermott, managing director of fund platform Chelsea Financial Services and fund ratings business FundCalibre said most global equity funds have a significant portion of their assets invested in the US market, and hardly anything invested in emerging markets.
He said a typical portfolio constructed on the basis of a large exposure to a global equity fund, and smaller exposure to individual regional or country funds provides diversification.
“In the short term we would never say to react to geo political tensions as they are often short lived.
The recent blow up between the US and Iran led to a short term spike in the oil and gold prices but didn’t effect US equites at all.
“If conflicts look more long term then you might want to reduce equities a bit but timing markets is notoriously difficult.
“Often markets will act before investors can move so more often not it is better to simply stay invested.”
House View: What the return of Middle East tensions could mean for markets
Markets are once again in thrall to geopolitics following recent events in the Middle East. Our research shows what such periods can mean for investment performance.
The recent assassination of Qassem Soleimani, the head of the Iranian Revolutionary Guards’ overseas forces, has reignited tensions in the Middle East and sent tremors through asset markets.
The oil price has risen sharply to over $70 a barrel at the time of writing, amid concerns that tensions in the region will impact supply.
Meanwhile, the value of assets perceived as “safe havens” such as gold, the Japanese yen and US Treasuries has also risen.
Indeed, the price of gold at one point on Monday hit its highest level since April 2013 ($1580 per troy ounce).
It is early days, but so far markets have responded as one might expect if you look at previous bouts of heightened geopolitical risk.
Last year our economists published research into the impact of geopolitics on markets.
They found that it can significantly impact investment returns and that an active investment approach can help navigate such turbulent times.
How does geopolitical risk affect markets?
Geopolitical risk can refer to a wide range of issues, from military conflict to climate change and Brexit.
We look at it as the relationships between nations at a political, economic or military level.
The risk occurs when there is a threat to the normal relationships between countries or region.
Heightened geopolitical risk tends to trigger investors to move away from riskier assets like shares and towards perceived “safe” assets.
This negatively impacts stock market returns, while government bonds benefit (particularly those with short maturities as they are perceived as the safest).
Geographically, investors also shift their money away from the perceived riskier regions such as emerging markets and towards developed markets like the US.
This is illustrated below, by the performance of four different assets (US shares, global shares, gold and US government bonds) during three major geopolitical events.
How did our analysis work?
Our economists Keith Wade and Irene Lauro looked at five different periods of heightened geopolitical risk since 1985.
To do this they used the Geopolitical Risk Index (GPR), which reflects automated text search results of the electronic archives of 11 national and international newspapers. It captures the number of mentions of key words such as “military tensions”, “wars” and “terrorist threats”.
They defined periods of geopolitical risk as whenever that index went above the 100 mark, which you can see below.
Our economists created a “safe” and a “risky” investment portfolio and compared their performances during these periods.
Of course, no investments are truly “safe” or risk free. Investment values go up and down and you don’t always get back the amount you originally invested.
We use the term “safe” merely to distinguish between the relative stability of assets like US government bonds (which the US government is highly unlikely to default on) versus shares, which are relatively “risky” (companies regularly go bust). We could equally have called them “less volatile” and “more volatile” portfolios.
What did our analysis show?
Our analysis shows that in the short-term the portfolio of “safe” assets delivers higher returns than the risky portfolio in three out of the five periods considered.
When the returns were “risk-adjusted”, this was also the case. Risk adjusted returns refers to the Sharpe ratio, which measures the return of an investment compared to its risk.
We also looked at how a diversified “60/40” portfolio (60% risky assets and 40% “safe” assets) compared. We found that it performed worse than the “safe” portfolio (both in total returns and risk-adjusted).
What if you wait until after the geopolitical risk subsides?
The results were particularly interesting when our economists extended their analysis to six months after the GPR index falls back below 100.
This enabled them to get a better idea of how an investor would have performed if they had held onto their risky portfolio through the turbulence and then allowed markets to recover their poise.
They found that over the extended time period the risky portfolio outperformed the safe portfolio in four of the five periods (the exception being 9/11 and the Iraq invasion).
The risky portfolio also scored better than the safe portfolio in risk-adjusted terms in each of these four periods.
However, an investor would have had to withstand considerable volatility to realise the benefits of the risky portfolio so we threw into the mix a “dynamic” portfolio.
This would involve an investor implementing a safe portfolio as soon as tensions start to rise (the GPR goes above 100) and switching to the risky portfolio when they dissipate (goes back under 100).
For an individual investor this would likely not be practical with their own portfolios.
However, it’s likely the best option for those who entrust an active fund manager that takes geopolitical risk into account.
This dynamic portfolio did well, delivering a higher return (both total and risk-adjusted) than the risky portfolio in three out of the five periods and higher than the safe portfolio in four out of the five periods.
The analysis showed that active fund managers can potentially avoid some of the losses and still enjoy much of the benefits from taking geopolitical risk into account.
 The safe portfolio allocates 50% to the US 10-year benchmark government bond, with the rest equally distributed among gold, Swiss franc and Japanese yen.
The risky portfolio comprises 50% in the S&P 500, the rest allocated evenly between the MSCI World and MSCI EM Equity indices. After 2007 we also include a basket of local EM sovereign debt made up of local currency sovereign bonds of Turkey, Brazil, Mexico, Russia and South Africa