Recent weeks have been riddled with uncertainty caused by the conflict in Iran and the significant disruption to energy supplies. It has yet again raised the question of how we should manage geopolitical risk in our portfolios.
The uncomfortable truth is that geopolitical risk is not just difficult to forecast; it is almost impossible to trade consistently.
Events unfold unpredictably, the risks are often binary and political risk is reflected differently in market prices depending on the underlying event.
Financier Nathan Rothschild might have profited from “inside information” to gain early news of victory at the 1815 Battle of Waterloo, but in today’s connected world every snippet of information is priced in an instant across markets.
That means investors trying to trade on any news may already be too late. For example, while I believe that commodities are a helpful diversifier, I was concerned that retail investors set a record by pouring $211 million into oil-linked ETFs on 12 March when energy prices had already surged by 40%.
A more effective approach begins with a shift in mindset. Instead of asking: “what will happen next?”, investors should ask: “how would my portfolio behave under different scenarios?”
At any one moment, market pricing represents a probability-weighted range of scenarios rather than a point estimate of returns.
Oscillations in the probabilities of risk scenarios can drive significant shifts in market prices. Thinking about the shape of the distribution of scenarios can help to assess the likely impact on portfolios.
Taking a long-term view
In a similar vein, rather than focusing on daily headlines and social media posts, we also need to step back and view geopolitical shifts in a broader context.
That means understanding the economic implications of higher defence spending and efforts to secure supply chains. This helps us to determine whether risks are leaning in a stagflationary, deflationary or reflationary direction. In turn, this allows us to think about the correlation between asset classes and build more diversified and resilient portfolios.
This buys time and allows investors to respond, rather than react to a crisis.
Next, while the eye of the storm might be difficult to predict, we can focus on those second and third-order effects.
Commodity prices tend to be the main transmission mechanism from conflicts to markets. But the next stage is to determine the extent to which a rise in commodity prices, or the broader economic disruption caused by a geopolitical event, leads to a growth shock or a rate shock. This is where fundamental analysis is crucial.
In 2022, the invasion of Ukraine had a significant impact on markets as it amplified the post-Covid surge in inflation and resulted in a dramatic shift in interest rates. While inflation risk is similarly under-priced today, the starting level of interest rates is significantly higher than in 2022, limiting the risk of a rate shock but potentially raising risks to growth given that the disruption to energy markets could be more significant.
Lastly, many commentators have remarked on the apparent complacency reflected in market levels: break-even inflation has barely moved, equity markets have ground higher and oil markets imply that the disruption to supplies will be short-lived. This is because any signs of de-escalation could rule out some of the more extreme scenarios in an instant. The headline risk is too elevated and so markets default to the assumption that cooler heads will prevail.
However, under the surface of the market, assessments about the relative impact of the crisis are being made across sectors and countries. It is at this level that there is more opportunity to identify positions that you might favour in a more benign base case but that would also pay-off if geopolitical tension persists.
For example, the US equity market benefits from higher exposure to tech earnings but is also relatively less vulnerable because the US is not reliant on foreign energy. Elsewhere, European government bond markets have priced in rate hikes in response to higher energy prices and would therefore benefit from a reassessment of inflation risk if the situation in the Middle East improves — but could also rally if energy prices stay high and start to pose a risk to growth.
Rather than reacting to headlines and trying to predict every twist and turn of events, focus on scenarios, second order effects and relative impacts to identify asymmetric pay-offs that can help you to build more resilient portfolios
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