Given the global and interconnected ecosystem of capital markets today, it is undeniable that we cannot afford to ignore geopolitical events concerning strategic allocation decisions. Trade wars and regional conflicts, political uprisings, or policy changes — all of these events can reverberate through financial markets that span equities to bonds; and commodities to currencies. In this post, we aim to analyze how macroeconomic events influence global asset allocation in the current environment and give some advice (not trade recommendations) for those who need to invest within them.
Understanding Geopolitical Risk
Geopolitical risk means the impact of political decisions, events, or conditions on business profit sustainability and investment stability. These risks can show up by way of:
Political instability
Trade disputes
Sanctions and embargoes
Regulatory changes
Regional conflicts
Terrorism
Cyber warfare
Changes in any of these can have a significant impact on the investment environment, requiring asset managers and retail clients to adjust their portfolio strategy.
The Ripple Effect on Asset Classes
What happens in one market can affect events in the other: these are geopolitical markets.
Equities
Equities are usually the first to react following a leveraged (read: long market) environment and with that equities responded — Reacted Other Than Lower. What about stock markets? As uncertainty rises, so does selling pressure within sectors most impacted by the events. For example, when political unrest spikes in oil-producing regions energy stocks may pull back but green plays move higher.
Bonds
In times of geopolitical turmoil, government bonds — especially those in stable countries — have been known to draw capital away from other markets and into the safety of one with a perceived zero risk. Investors, in turn, tend to pile into these securities which pushes prices higher and yields lower. In contrast, bonds issued by countries engaged in the conflicts may well suffer as investors require higher yields to accept a heightened risk premium.
Commodities
Commodity markets are strongly influenced by geopolitical events. For example, the sensitivity of oil prices to Middle East conflicts is no secret. Agricultural commodities and industrial metals are also vulnerable to trade disputes.
Currencies
Because market effects occur quickly in the currency world about developments of a geopolitical nature. For example, when the political situation in a country is not stable its currency will be depreciated; Meanwhile, Swiss franc and Japanese yen are regarded as safe havens so the value of these two tends to rise amid global uncertainty.
Strategies for Navigating Geopolitical Risks
As geopolitical events have a wide potential of turning around whatever is happening in the investment world, investors and asset managers should provide strategies to reduce exposures whilst taking advantage of them.
1. Diversification
Don’t put all your eggs in one basket: The long-true theory prevails here too. Moreover having a well-diversified portfolio that includes asset classes, sectors as well geographical diversity should cushion the impact of these geopolitical shocks.
2. Scenario Planning
Investors should focus on developing multiple scenarios for their global portfolios and stress-testing those against possible geopolitical events. This means agile responses to events.
3. Active Monitoring
Keep up with international politics Constant re-evaluation of the geopolitical milieu and its resultant effects on investments can aid in taking timely actions.
4. Hedging Strategies
By hedging your oil risk, trading options, or futures you can ensure that when crude prices oscillate lower and higher from some of those aforementioned volatile events.
5. Long-term Perspective
Geopolitical issues can create volatility over the short term, but by sticking with an investment plan grounded in a long-term time horizon investors may be better positioned to weather temporary disruptions and concentrate on core value.
6. Opportunistic Investing
Political shocks sometimes create value. While short-term investors continue to balk at the prospects of near-term Pain, longer-term value types may find emotionally attractive entry points amongst oversold assets or sectors that they otherwise detest this week.
Case Studies: Geopolitical Events and Market Reactions
We take a look at the effect of possible geopolitical events on asset allocation through examples.
Brexit (2016)
That the UK would leave the European Union was immediately apparent from swings in global markets. The British pound tumbled, UK and European stocks fell lower, while demand for safe-haven assets like gold soared as investors sought out something less risky (update).
US-China Trade War (2018-2020)
The United States and China, the world’s two largest economies, exchanged blows on trade over the weekend with neither appearing poised to back down from a bitter dispute that is set to drag into September. Scroll video for more details The tit-for-tat conflict between Beijing and Washington saw new tariffs imposed Friday as US President Donald Trump raised punitive duties of 25 percent each on $200 billion in Chinese goods while further restraining tech giant Huawei. Then some of those same markets started to cool and slow global economic growth.
COVID-19 Pandemic (2020)
An epidemic was able to turn into a pandemic given the complexity of our geopolitical situation: conferencegoers flew back from Wuhan around Asia and beyond while many countries tried different responses (the UK versus France). After which, there was a global sell-off in the market and each country or even sector started recovering on their own.
The Future of Geopolitical Risk Management
This means how geopolitical risks are managed evolves as long-lasting and impactful events continue to shape the global investment landscape:
Analytics — Thanks to the increasing efforts towards the adoption of big data and AI in geopolitical risk analyses, today we can provide more refined information at a faster pace.
ESG factors: Environmental, social, and governance (ESG) integration — Geopolitical risk has evolved to consider ESG alongside traditional geopolitical risk assessments given the interconnected nature of these issues.
Localizing Strategies: More companies and investors are likely to adopt a local approach to protect themselves from global geopolitical instability while also diversifying risk through their supply chains and market exposure.
Looking forward, this transformation is only set to deepen as investors adjust their global asset allocation decisions for froth ripple effects from every corner of the world. That they add layers of complexity and uncertainty to the investment process, but also introduce opportunities for those who are prepared (and adaptable). Geopolitical risk is here to stay, but capturing the three streams of diversification (investment class & geography), vigilance, and agility into financial market investing—to create a more cohesive investment strategy necessary for long-term sustainability within an ever-changing global landscape.
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