While the impact of geopolitical tensions on portfolios tend to be short-lived, they are triggering several structural changes in the economy and society, with significant investment implications.
With escalating tensions in the Middle East, ongoing conflict in Ukraine, trade war between the US and China, and uncertainty around the November’s US presidential elections, geopolitics has become a key concern for wealthy investors. But are their worries justified?
Private banks’ chief investment officers and market strategists who took part in PWM’s ninth annual Global Asset Tracker study conducted earlier this year, indicate geopolitics as the top risk for financial markets, in terms of likelihood, in 2024. But the impact of geopolitical shocks on markets is not regarded as significant as that of macroeconomic fundamentals, including central banks’ monetary policies, inflation, and interest rates.
“Geopolitical risk has picked up significantly in terms of the number of client conversations we have about it,” confirms Willem Sels, global CIO, Global Private Banking and Wealth at HSBC.
Disruption to global supply chains, because of the Covid-19 pandemic, US trade tariffs, and automation, are leading not only global firms, but also business owners – many of the bank’s clients – to “actively look for supply chain diversification”, as the long-term trend towards a multipolar world gains traction.
But when it comes to investment portfolios, geopolitical events are most likely to just cause short-term volatility in markets, which needs to be hedged. They rarely generate longer-term shocks, says Mr Sels.
Global portfolio diversification, across asset classes and geographical regions, is the most effective way to protect portfolios from these shocks, which are difficult to forecast, and is especially important for business owners, who typically have a huge concentration of their activities in their home market, says Mr Sels.
Diversification helps reduce risk but also broadens the opportunity set, with secular growth opportunities in Asia emerging beyond China, for instance. “Supply chain diversification is one of the key cornerstones of the widening opportunity set within Asia,” he says. He stresses the importance of “putting cash to work” in the current environment, and the appeal of infrastructure investing, supported by the mega trends of decarbonisation, digitalisation, deglobalisation and urbanisation.
Energy security
History shows 90 per cent of geopolitical events have not changed the direction of the world economy, according to Citi Global Wealth. Of the 25 significant security and political shocks around the world, since the Pearl Harbor attack in December 1941, only the second world war and the Opec embargo of 1973/1974 caused a ratcheting down in economic activity, explains Steven Wieting, chief investment strategist and chief economist at Citi Global Wealth.
But most of the world’s petroleum supplies no longer rest in the hands of one cartel or country, as in the 1970s, and the possibility of an inflationary recession is notably less. Today, the US produces more crude oil than any other nation, while Europe has cut its dependence on Russian oil.
“The track record of geopolitical shocks is very helpful to have clients understand that, for one, they might, in some cases, be taking too much idiosyncratic risks, especially if they live and have businesses close to a conflict zone,” says Mr Wieting. But clients very distant from these events “worry about them too much and attach too much impact on the economy” than warranted, says Mr Wieting.
Geopolitical shocks are unpredictable, and when they occur, markets adjust very fast. The events of 2022 and 2023 have also shown the adaptability of the global economy. “With the conflict between Russia and Ukraine, there has been a tremendous redirection of world commodity flows, food, natural gas and oil,” he says. Indeed, the global price for Brent Crude oil has remained stable to the level it was before Russia’s invasion of Ukraine, even after the widening of the conflict in the Middle East, with Iran’s direct attacks on Israel.
Yet, geopolitical risks do affect asset allocation and overall risk tolerance. “While global supply shocks are very rare, they still suggest we should invest with a range of possible positive and negative economic outcomes in mind, rather than build portfolios that only seek the highest absolute return, regardless of risk,” says Mr Wieting.
Heightened geopolitical risk to oil supplies suggests greater need for investment in energy security, or “redundant energy supplies”, even as energy demand is being satisfied by a new mix of energy sources. Investors should therefore consider investments in Western energy supplies, from conventional fossil fuels to alternatives, which may mitigate such risks.
In addition, economic security requires defence deterrents, cyber-security defence and increased tech supply chain investments. “These are all robust long-term growth investments in equity markets, despite their usual volatility,” says Mr Weiting.
As a result of heightened risks, the bank maintains a “cautiously positive” 2 per cent overweight allocation in equities, with an “overweight exposure to dollar assets”, not just because of the comparative resilience of the US economy, but also because of geopolitical events, which have negatively impacted Europe’s growth rate, “although this may be already in the price”.
Investors, though, can today once again rely on high quality bonds to reduce risk in portfolios, with Citi focusing on high-grade US bonds at a medium average duration. “At yields 10 times the yield of 2020, high quality bond yields are more likely to be able to provide a buffer for portfolios in the event of shocks.”
Fractured world
While wars and geopolitical shocks are unlikely to produce lasting impact on markets, they are triggering several structural changes in the economy and society, with significant implications for investments too.
Higher prices are a key consequence of deglobalisation, which is an outcome of geopolitical shocks, believes Christian Nolting, global CIO, Deutsche Bank Private Bank.
“In the past, firms wanted to produce where it was cheapest. Now they are ready to pay a higher price to have a stable supply chain, which forces further deglobalisation and is inflationary. That trend won’t go away,” he predicts.
This means rates will be higher for longer, which should lead investors to prefer “price makers, rather than price takers”. These are most likely to be found in large cap stocks, which are outperforming small caps at a stage of the market cycle where the opposite should be true.
Investors should also focus on companies able to distribute money, deliver productivity gains and increase growth rates. “Those firms who pay high dividends, who do a lot of share buybacks are doing quite well, especially in the value space,” says Mr Nolting.
In this rather inflationary environment, Deutsche Bank focuses on sectors able to produce growth, such as technology, and healthcare, which increases productivity gains. Consumer discretionary is also an attractive sector, being less impacted by inflation than consumer staples.
Structural higher inflation and structural interest rates are also the result of greater government spend on defence and cyber security, says Manuela D’Onofrio, head of global investment strategy, UniCredit Group. “We live in a more aggressive world, in which countries, especially superpowers are more willing to go to war rather than use diplomacy,” she says.
Over the next decade, Europe will have to double its spending on defence, which today lies far behind the US’s 4 per cent of GDP, which for the eurozone will represent a new step towards greater integration, she believes.
“This kind of environment creates big disruption and opportunities,” she says, pointing to the role of new technology such as AI, also in the development of weapons. Despite huge expansion of multiples, innovative, tech companies need to be in investors’ portfolios, especially over the longer term.
Other asset classes, such as gold, are greatly benefiting from the trend to a “more fractured” world and are key for building “highly diversified portfolios”, says Nancy Curtin, global CIO at AlTi Tiedemann Global.
“Today the world divides into three camps. You're either with the West, against the West, or something in between. The inbetweeners do what they want that aligns with their national interests,” she says.
The world is “no longer about Kumbaya, where we all get along. It's much more of a multipolar world that can bring fractions and tensions. Gold is an interesting store of value in that context,” believes Ms Curtin.
Also, gold is an interesting “strategic store of value” in a world that is much more indebted, which reduces the level of safety in government debt.
“In this multipolar world, countries prioritise national interest and will need to invest in infrastructure, to secure access to energy, to be able to control their own destiny, with respect to accessing technologies across the world. We think infrastructure investing is a multi-decade theme.”
With revenues indexed to inflation, infrastructure will also provide inflation protection in portfolios, in case of commodity price shocks, she says.
The US, especially, has a strong desire to bring supply chains, and the manufacturing base, back home. This will require infrastructure, transport, roads and ports. While having different expenditure programmes, neither US presidential candidate has “fiscal prudence at the top of the agenda” says Ms Curtin. But deficit is not a bad thing, if the expenditure is investment related, and catalyses infrastructure spend, contributing to the competitiveness and solidity of the US, she says.
She cites President Biden’s approval of $39bn worth of support for the creation of semiconductor Fabs – fabrication plants turning raw silicon into integrated circuits – in the US, to decrease dependency from Taiwan, programmes like the Chips act, to encourage US companies to build new chip manufacturing plants in the country, and the Inflation Reduction Act to accelerate the climate transition. All are infrastructure programmes that can catalyse private sector investment and create jobs and “contribute to make the US a great place to invest”.
Portfolios also need to be built keeping in mind the higher interest rate structure, as yields are unlike to go back to the ultra-low levels of the post 2008 world. “We have left a borrowers’ world. We are now in a lenders’ world, where credit is very interesting,” she says. “We're seeing very nice returns from private credit.”
Lessons learned
‘Known unknowns’ such as geopolitical events are “a great test” to understand whether clients’ strategic asset allocation is right, says Deutsche Bank’s Mr Nolting.
“If geopolitical events have potential to influence the client’s strategic asset allocation, it means they are in the wrong strategic asset allocation,” he adds. The biggest lesson advisers have learned over the past few years is how the most important discussion with clients is “around the risk they are able to bear, and downturn they are able to sustain”, considering their needs and circumstances.
To help clients avoid taking “emotional kind of wrong decisions”, Deutsche Bank uses ‘tail risk hedges’, hedging client portfolios with ‘long puts’, to cover peaks in volatility, with higher allocation to equities compensating hedging costs.
“In the past, more clients would panic sell, but they have now understood they need to stay with their strategic asset allocation, diversify and take hedges into account. By buying hedges, they are buying volatility, which brings the price down. As a result, volatility in equity markets is very low and is not going to increase,” he predicts.
The key factor to take into consideration, when analysing the impact of geopolitics on portfolios, is that “a major driver of US politics is to contain the power of China at all levels,” says UniCredit’s Ms D’Onofrio. “The US will do whatever it takes to maintain its economic, military and political supremacy in the world, regardless of who is going to be the next president, be it Democratic or Republican,” she believes.
This has major implications for investors. “Geopolitical factors are not among the first three or four risk factors I consider when I invest client money. But I do make sure to invest in countries and companies that have a very low risk of being targeted by US sanctions. This is very important to me,” she says. With UniCredit still having a presence in Russia, the bank had first-hand experience of what sanctions imply.
This increased attention to sanctions leads Ms D’Onofrio to recommend a “limited exposure” to emerging markets, despite “very good valuations”. Since Russia’s invasion of Ukraine, her preference has been for developed equities, with a focus on the US, Europe and Japan.
“Bric (Brazil, Russia, India, China) countries, which have a big weight on the EM index, are not strong allies of the US or of Nato. We don't want to invest in countries or companies that have a high probability of getting sanctioned.”
In hindsight, what she has learned is that “every time that there is such a war, you should increase risky assets.
“When Russia invaded Ukraine, we already had a neutral position on equity. We never sell when there is panic in the market, but maybe we should have been more aggressive and increased the exposure to risk assets.”
The impact of geopolitical shocks on markets, through the price of crude oil, is limited also because recent wars have confirmed that sanctions do not work. “Sanctions are just a transfer of wealth,” she says, pointing to how some countries and companies bought oil from Russia and resold it to the market, albeit at a higher price, when Russia invaded Ukraine.
This “triangulation of transfer of goods” contributed to prevent the oil price from going through the $100 psychological barrier at the time of invasion and this year too, with escalations of tensions in the Middle East and attacks in the Red Sea, with limited impact on inflation, economy and markets.
Looking forward to potential geopolitical shocks, Citi’s Mr Wieting mostly worries about supply shocks, pointing to the world’s massive reliance on semiconductor supplies from Taiwan, and the fact that Russia and Iran represent about 20 per cent of global oil output. Oil price is very reactive to supply chain pressures, although this is usually short lived, he says.
While not overly concerned about the potential impact of a Trump presidency on trade tariffs, he warns that after the high inflation in 2021 and 2022 “anything that stands in the way of lower, more stable consumer prices could have a larger psychological impact on markets”.
