Global tensions do not necessarily mean avoiding riskier investments
Geopolitical risk has increased uncertainty in the financial markets, but charities should consider carefully before moving their money.
What’s the one word you would choose to characterise global politics over the past few years? Confusing, surprising, dramatic, relentless? It certainly feels like geopolitical drama has never been far from the front pages. Whether the war in Syria or the war on Twitter; the tension around the globe has certainly increased over the past 20 years.
Geopolitical risk can encompass a wide range of issues, from military conflict to climate change and Brexit. It tends to describe the relationships between nations at a political, economic or military level. The risk occurs when there is a threat to the normal relationships between countries or regions. But can it be measured and how does it affect investment markets?
Economists at the US Federal Reserve have attempted to measure geopolitical risk with an index using automated text searches of 11 national and international newspapers. It captures the number of mentions of key words such as "military tensions", "wars" and "terrorist threats".
It shows two clear occasions over the past 20 years when there was a marked increase in geopolitical risk. The first, unsurprisingly perhaps, was following 11 September 2001; with risk levels remaining heightened as the war on terror escalated. The second step up in geopolitical risk coincides with the election of President Trump, and his combative approach to global trade.
But how does this affect investment markets? Geopolitical risk creates uncertainty. It weighs on economies and financial markets as decision-makers hold off from making major commitments. Firms delay investment decisions or new hires. People delay spending on big things like cars and houses. Investors delay their decisions as they try to assess the economic or political impact.
The creators of the geopolitical risk index – Fed economists Caldara and Iacoviello – found that significant increases in the index result in weaker economic activity and lower equity market returns. Industrial production, employment and trade are all hit, with the adverse effect persisting for a year after the initial shock.
Interestingly, the analysis found that economic activity and financial markets were more affected by geopolitical threats than by actual events. Threats tend to increase uncertainty and downside risks, while actual events tend to resolve uncertainty and prompt protective policy responses. This finding reinforces the stock market adage to "buy the rumour, sell the fact".
Over the next decade we see two factors driving geopolitical tensions: the continued increase in the size of the Chinese economy and the rise in inequalities in the major economies. So should we just run for the exit and keep our charity assets in cash?
Our analysis does suggest that "safe" investments such as bonds do much better than 'risky' investments during periods of high geopolitical risk. However, if you extend the time horizon to just six months after the normalising of the geopolitical risk index, the risky portfolio outperforms.
Which means that for long-term charity investors, although volatility is uncomfortable, sticking with investment portfolios through periods of geopolitical turbulence is likely to prove rewarding.
This article first appeared in Third Sector.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
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