In a way, “geo-political” has become the word of the year. It means the interplay on a global level of politics, markets and countries.
Geo-political risks, both perceived and real—such as wars, terrorist attacks, political instability, and trade tensions—are a staple of our news and, at times, completely dominate the headlines. While such events can have profound impacts on the lives of individuals, communities and nations impacted, do they matter for long term asset returns? In this article, research firm Māpua Wealth looks at what the empirical literature suggests, and the implications for investors.
Geo-political risk impacts in principle
As with most things in markets, it is useful to distinguish between the short and longer terms. Over the short-term the literature suggests geo-political events can lead to abrupt share market sell-offs, increased volatility and a premium for taking on market risk. But crucial is the proximity of the event to the market concerned, the magnitude of the event, and the impact across different sectors and countries.
The literature also suggests that the link is coincidental between such events and market volatility and short-term declines in share markets. In other words, it is exceedingly difficult to forecast future returns given geo-political risks.
The longer-term impacts depend on how the ‘shock’ is resolved, and whether it has an enduring influence on economic growth, corporate earnings and profitability. In general, we can say that over time markets recover even from the largest of such events like world wars. But that is not to say there aren’t enduring impacts on specific companies, sectors or even countries and regions.
Case study – Russian invasion of Ukraine
To illustrate this with a recent example, the full-scale Russian invasion of Ukraine in February 2022 had the largest short-term impact on neighbouring countries. Poland and Hungary’s sharemarkets fell around 40% and European sharemarkets overall initially fared worse than the US. But in the year following the invasion European shares had fully recovered while the US market was down around 9%, even though European economies were much more negatively impacted by rising energy prices. And now, nearly three years on, most share markets have reached new highs, with the US leading the pack. In contrast, Russian share markets have become un-investable following the dropping of their markets from indexes and funds.
Nevertheless, there have been enduring impacts. Energy markets have been completely re-configured within Europe and some commentators suggest the war has hastened the transition away from fossil fuels. Defence industry spending has rocketed up. In contrast, most Western companies with Russian ties have essentially had to write-off their business and assets held within Russia.
Implications for investors
For investors, diversifying across markets and asset classes is essential for managing geo-political event risk, in line with managing market risk in general. Bonds typically do well when there is an increase in short-term global uncertainty and share market volatility. You can mitigate the ‘shock’ that has an enduring negative impact on a country or sector by holding a wide number of investments, across different sectors and countries. And time, as always, is the ultimate diversifier. Most markets, most of the time, recover.
Another implication of the literature is that it is likely to be both unfruitful and potentially counter-productive to adjust a portfolio in response to geo-political risk. Many forces have an impact on markets, and as mentioned earlier the medium and longer run impacts are very uncertain. As an example: an investor who sold European shares after the Russian invasion to buy, say, US shares, on the view that the European economy would be more at risk, would have been right about the economic impact, but wrong about the impact on markets over 2022. Defence spending has massively increased since the invasion, but defence stocks overall have not outperformed.
Finally, while we caution against reducing exposure to risky assets because of concern that geo-political risk will have an impact on future investment returns, there may still be good reasons to adjust based on ethical investment considerations. Many investors sold (or wrote off) their holdings of Russian stocks on ethical grounds following the invasion of Ukraine, which in the event was facilitated by fund managers and index providers dropping these exposures in response to Western government sanctions.