CIO Tutorial: How can investors manage political risk?

As seen in early 2022, with the conflict over Ukraine, such crises can cause considerable market volatility. But what makes a political crisis worry investors, how can it impact markets, and what can you do to help protect your portfolio?

Overall, political and geopolitical risks could weaken economic activity, reduce investment returns and lead to flight from riskier assets. But they are important to put into context. Even when crises affect major nations and threaten key resources or trade, these effects tend to be short-lived. Since the attack on Pearl Harbor in 1941, the S&P 500 has been higher three-quarters of the time 12 months after a crisis began. Half the time, markets only took a month to recover, according to an analysis by Truist based on FactSet data.

It should be noted that US stocks have risen about seven in ten years since World War II, so fortunes generally favor cool heads. It also supports the argument that geopolitical crises rarely cause global economic downturns, with the Arab oil embargo being a notable exception.

In addition, most political crises with the potential to cause significant damage either end with a diplomatic solution or become chronic rather than acute, disputes that only occasionally make headlines when tensions erupt. The strained relations between North Korea and the United States, which erupted in 2017, are an example of a crisis that has been going on for years without, at least so far, escalating into a full-scale conflict.

How can investors help defend against geopolitical risks?

Unfortunately for investors, there is no single cover. The perfect hedge would depend on the nature of the crisis, which is impossible to predict. Even so, investors can apply these general principles:

1. Diversify geographically. Most geopolitical crises will affect some nations more than others. Since you can’t predict where the surge will occur, maintaining a geographically diverse portfolio is the best baseline hedge.

2. Consider some exposure to “safe haven” assets. These can include gold, Swiss francs, US dollars, Japanese yen, US Treasuries, low beta stocks and some hedge fund strategies. However, it is not a static category. A selection of defensive investments, diversified in their own right, can help reduce volatility.

3. Explore hedges that have upside potential even if the crisis does not worsen. The best hedge is one that you expect to increase in value over the long term even if the geopolitical crisis is resolved, but which would outperform if the crisis worsens.

4. Keep a long-term view. Geopolitical risks rarely have more than a passing impact. So try to avoid being caught in a panic and don’t sell in a crisis. Plus, there’s almost never a time when there isn’t a potentially significant political crisis on the horizon, so put those into perspective.

5. Build a “buffer” against volatility. When it comes to managing the risk in your portfolio, whether it comes from a geopolitical shock or another source, the priority is to ensure that your portfolio is designed in such a way that short-term volatility Futures markets do not interrupt your ability to achieve your goals.

What does all this mean now?

Geopolitical risks have come to the fore again due to the dispute between Russia and NATO over Ukraine. As is often the case with geopolitical crises, events move quickly and opinions can quickly become stale. However, we have a clear view of the best way for investors to position themselves.

In our last Global Risk Radar publication, we argued that both sides will ultimately calculate that military conflict has an economic and political cost too great to be worth. For Russia, tougher sanctions would hurt its long-term growth prospects, and domestic sentiment could deteriorate rapidly, as exemplified by protests in Belarus in 2020, Russia in early 2021, and Kazakhstan this year. The European Union would also suffer significant consequences, given that Russian energy accounts for almost 40% of its gas imports and 30% of its oil imports. As for the United States, the European security situation is distracting from President Joe Biden’s plans to reinvigorate the US economy amid falling approval ratings and already high energy prices.

In this context, our advice to investors is:

1. Diversify and keep a long-term view. It is important to remember that stock market declines caused by events of geopolitical tension are usually short-lived.

2. Consider geopolitical hedges, including commodities. This is relevant for investors who are worried about an escalation scenario. We note that when geopolitical events are accompanied by a supply-induced oil price shock, markets have historically tended to take larger losses and have taken somewhat longer to recover. This makes allocations to commodities and energy stocks an attractive option, in our view, to help investors hedge portfolio risk.

3. Buy global growth winners. Despite the recent volatility, it is important to remember that we are still in an environment of robust economic and earnings growth and in our base case scenario we expect equity markets to rise for the rest of the year. .

Main contributors: Christopher Swann, Dirk Effenberger, Daniil Bargman, Dominique Huber, Justin Waring

The content is a product of the Chief Investment Office (CIO).

See the full report – CIO Tutorial: How can investors manage political risk?February 17, 2022.

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