A Geopolitical Tragedy
Key Takeaways
Research confirms that geopolitical risk is not something we should worry about when it comes to asset allocation and investing.
There are only two important circumstances that affect stock markets directly and creates bear markets: Recession, and Financial Crisis.
Markets don’t go down on war worries alone. Although it could spill over and affect the global economy, the slowdown will be captured in relevant market data which is something that we constantly keep track of.
Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.
— Peter Lynch
Geopolitical risk features quite high up in a lot of the conversations we have with clients. These worries start to rise whenever we see and read about such conflicts in the news. This has been more prevalent since the Russian invasion of Ukraine (although we hardly see much info about it these days). At the moment, the Middle East conflict between Israel and its neighbours tends to feature in more discussions.
It is a natural worry, that the threat of conflict or war logically should make markets perform poorly. It doesn’t help that it is reported quite a lot in the news during periods of heightened tensions. In addition, commentators tend to allude to poor market performance as well.
Straits Times Headlines
Markets continue climbing, but with wary eye on economic and geopolitical developments.
Geopolitics, data flows cast long shadows over investor sentiment.
Then, we also have firms like the Eurasia Group which consult on the effects of politics on markets and tend to issue bearish forecasts year after year. In particular, in their 2017 report following the election of Donald Trump to the US Presidency, they noted that the world would be in the most volatile political risk environment since WWII, with market risks on par with the economic recession of 2008.
Hopefully, not many investors took their advice to heart and changed their asset allocation because global stocks ended the year with double-digit returns, with short-term treasuries (as a proxy for cash or safe instruments) ending with negative for that year (2017).
Typically, geopolitical risks are not a useful tool for investment allocation, nor are they good as a signal that helps you to decide when to be fully allocated to risky assets or to hold cash (not that market timing is useful to begin with anyway). You can see the chart overlay below.
You will see that spikes in geopolitical risk (in red) do not exactly correlate with market drawdowns. The spike in the early 90s did not lead to a large sell-off. The spike in 2001 was due to the September 11 terrorist attacks in the US, but at the time the dot-com bubble selloff was already well under way. The recent spike in 2021 occurred halfway through the year, already near where the market was bottoming.
Still Unsure?
However, sometimes our eyes may deceive us, so let’s use statistical regression to confirm whether geopolitical risk is something we should worry about when it comes to asset allocation and investing.
The result? The scatter plot shows randomness — indicating no relation between a rise in risk and a corresponding decline in equity returns.
In addition, many studies have been done over the years which shows that wars, do not have a lasting impact on stock markets. There are only two important circumstances that affect stock markets directly and create bear markets:
Recession, and
Financial Crisis.
Violence ≠ Volatility
For instance, a 2013 study found that the stock market’s average volatility was significantly lower during four major wars of the last century: World War II, the Korean War, the Vietnam War, and the first Gulf War. Large-cap stocks were 33% less volatile during these four wartime periods than across all periods since 1941, while small-cap stocks were 26% less volatile.
Logically, when the stock market is less volatile, it tends to trend higher. Large-cap stocks gained 1.4 percentage points more per year during these four wartime periods than the rest of the time, while for small-caps, the margin was 2.2 percentage points.
An overlay of the S&P 500 with historical crisis events shows that lasting effects on the stock market were caused by recessions (namely the big ones following the dot-com bubble and the 2008 global financial crisis. For the most part, the stock market gets over other events quite quickly.
Nevertheless, living through such a period and watching as your investments go down is worrisome. A good way to ensure that you do not expose yourself to unnecessary risks is to hold a portfolio which has clear expectations of losses during stressful periods.
Often, investors buy products looking only at the upside, and get surprised when the investment collapses during a volatile season. Broad diversification also helps to ensure that you do not expose yourself to concentration risk which can lead to higher losses when markets are doing poorly.
If you are worried that the myriad of global conflicts may affect your investments don’t be. Markets don’t go down on war worries alone. However, if fighting spills over and affects the global economy, the slowdown will be captured in relevant market data. This is something that we are constantly keeping track of e.g. recession risk and financial stress indicators. Like the quote at the beginning of the article notes — preparing for a correction may sound clever, but it more often than not has come at a big opportunity cost for your goals.
For more information on some of the underlying signals that we use as data points for investment decisions, come and speak with us.
