As the Ukraine/Russia war continues and friction emerges across the Middle East, it is important to be aware of geopolitical risks and their impact on global markets. As we have seen in the past, they can significantly weaken the global economy, which then filters down into national economies and specific sectors.
Understanding geopolitical risks
Each instance of geopolitical risk will have different characteristics and is often driven by differing intentions. However, there are four main elements to geopolitical risk, which include:-
· Political instability
· Economic sanctions
· Trade wars
· Regional conflicts
If we look at trade wars, there is an ongoing dispute regarding tariffs between the US and the EU. We also have a similar issue with the UK and the EU, which is taking some time to resolve. As we know, the greatest fear of markets is the unknown, even if the indications suggest US and UK issues with the EU will eventually be resolved.
Reviewing the current geopolitical landscape
As we touched on above, the conflict between Ukraine and Russia and growing friction in the Middle East are perfect examples of geopolitical hotspots and areas of tension. We often see other countries become involved in these issues, looking to offer support, arrange truces or trying to find long-term solutions. In some cases, these attempts can cause even greater friction and expand what may initially have been a local issue into a global issue.
There are many different triggers for geopolitical issues, such as:-
· Competition for resources
· Economic interests
· Ideological/religious differences
· Globalisation of industries
· Nationalism
· Technological advancements
· Climate change
· Power shifts
In the vast majority of cases, solutions will eventually be found, but in the meantime, there can be a vacuum of information and difficulty in seeing the long-term landscape.
Impact on global markets
History shows that all geopolitical issues will, to varying degrees, impact investment markets such as:-
· Equities
· Commodities
· Bonds
· Currencies
Very often, we see a knee-jerk reaction and then a period of consideration, which helps create a vision of the long-term future and slowly calms most investors.
Investor sentiment
Ultimately, whatever type of geopolitical issue we are looking at, investor sentiment will determine the short-term movement of markets. We often see switches in investment classes, perhaps from equities to more stable bonds, and other so-called "safe haven" assets. This is where diversification and hedging strategies come into their own, providing a degree of support and protection against short-term uncertainty.
Historically, huge events such as the pandemic (although not strictly a geopolitical issue) have prompted a high degree of volatility in markets. It is incredible how markets learn to cope with these challenges, reprice equities and bonds, and then begin to look to the future with a little more confidence.
Investment strategies
History shows that the most successful investors tend to have a long-term timeline, although they are obviously conscious of short-term challenges. This brings in the role of active and passive investment management strategies, the dangers of a knee-jerk reaction and the inability to see the woods for the trees. Many believe that one of the greatest dangers for investors is being "out of the market" because the best market days often follow the worst.
So, you may have made the right decision to reduce your exposure or leave the market altogether, but when do you go back in?
Summary
When looking at geopolitical issues, diversification and a degree of hedging can be very useful in putting your mind at rest and avoiding knee-jerk reactions. Amid vast geopolitical challenges or issues such as the pandemic, it can be challenging to maintain a balanced approach when markets are highly volatile. Human nature often dictates that we push markets beyond fair value in the good times while often assuming a worst-case scenario in difficult times, prompting oversold scenarios.
The key is to rise above the market mayhem, maintain a long-term strategy while being acutely aware of short-term volatility. Not easy by any means!