Lynn Strongin Dodds looks at how geopolitical risks have impacted markets.
It is no surprise that geopolitical risk tops the list of main concerns for financial service firms on DTCC’s annual Systemic Risk Barometer Survey. This is not a new phenomenon, but it has come back with a vengeance due to the unexpected and prolonged war in Ukraine, bubbling tensions between China and Taiwan, the US and Iran, just to name a few.
As a recent paper by risk and advisory firm Kroll points out, “Geopolitical risk is a constant, but in the midst of a pandemic, a war in Europe and a climate transition that is not nearly as advanced as it needs to be, the nexus between geopolitics, economics and business seems to have tightened.”
Establishing links between stock market performance and geopolitical risks tend to be the hardest to gauge as they have the widest range of outcomes. Unfortunately, often these events also involve human suffering and the loss of life, making them more painful. For example, there have been 18 “acts of war” since World War II and each of these periods engendered different results.
Research from Royal Bank of Canada shows that during this period, the S&P 500’s sell-off was limited to 6.2% on average and took 30 trading days to get back to even. Moreover, although many of these hostilities were lengthy, markets fully recovered well before a resolution was struck. The two larger corrections, the Arab oil embargo in 1973 and the Iraq invasion of Kuwait in 1990, were associated with major disruptions to energy markets, which resulted in longer-lasting negative economic impacts.
Back to the future
The question industry participants are now asking is how markets are behaving today and whether there are any differences. In many ways, the environment is akin to the 1970s which saw rampant inflation and soaring interest rates. Due to the fixed coupons in bonds, the higher inflation forecasts had a negative impact on returns while lower than expected output, under adverse supply shocks, negatively affected expected dividends and, as a result stock returns.
The same scenario is playing out now. “One of the big surprises of 2022 was that equities suffered at the same time as government bonds – since the start of the century, there has been a tendency for equities to rise with government bond yields, but not this year,” says Paul Jackson, global head of asset allocation research at Invesco.
In fact, research from Morningstar shows that the five-year rolling correlation of stocks and bonds is at a 20-year high. In the US market, the S&P 500 dropped by more than 20%, while yields on 10-year US treasuries were pushed to 2.5%. In the UK, the FTSE100 slid by 4.5% as the yield for 10-year gilts was almost 2.4%.
“In the post-2000 decade was characterised by an environment where demand shocks were dominant; large supply shocks were essentially absent” says Nabeel Abdoula, deputy CIO, Fulcrum Asset Management. “The major recessions were driven by demand shocks and monetary policy has been largely offsetting macroeconomic shocks rather than a source of volatility in itself. This created a meaningful negative correlation between equities and bonds, and a positive correlation between equities and commodities.”
Today, as in the 1970s he notes that the environment is dominated by supply shock. “There are huge liquidity injections in the economy; geopolitical shocks affecting energy and food markets and central banks underestimating the pervasiveness of inflation,” he adds.
Uncertain times
Although it is difficult to predict the future, “global tensions between the US, China, Russia and Europe will dominate political and economic events in the coming years,” says Björn Jesch, global CIO at DWS. “The world will be a different place than it has been in the last five to ten years. The population in developed countries is shrinking, combating climate change will require huge investments and Europe will have to break new ground in energy supply.”
He believes that “the biggest geopolitical risk factor is currently Russia. The eurozone economy is suffering particularly badly from the consequences of the Russian war of aggression on Ukraine. However, it has held up surprisingly well so far with growth of 3.2% despite the sanctions.”
Europe has been hardest hit by the war, with the MSCI Europe ex UK down 11.7% year to date. “The EU is among the most exposed advanced economies to high prices, due to its geographical proximity to the war and heavy reliance on gas imports from Russia. The energy crisis is eroding households’ purchasing power and weighing on production,” according to a statement from the European Commission.
Inflation, of course, is the linchpin. It will remain high, but levels will depend on the direction of the war in Ukraine and how long sanctions against Russia will remain in place. In addition, there is uncertainty over the impact of adopted or planned fiscal energy measures on energy inflation.
“High energy costs are expected to affect corporate margins and household purchasing power, and thus trigger a recession over this quarter and next,” says Raphaël Gallardo, chief economist at Carmignac. “The recession should be mild as high gas storages should prevent energy shortages. However, economic recovery from the second quarter onwards is expected to be lacklustre, with businesses reluctant to hire and invest due to continued uncertainty over energy supplies and financing costs.”
The UK is expected to fare worse. The economy is set to deliver the worst performance of all G7 countries next year, according to a forecast from the Organisation for Economic Co-operation and Development (OECD). The international trade organisation predicted the UK’s economy will contract by 0.4% in 2023 – more optimistic than the UK’s own Office for Budget Responsibility’s estimate of 1.4% of negative growth – but still lower than any other major economy.
Britain’s recovery is also set to be weak and only grow by 0.2% in 2024 although the OECD said the “risks to the outlook are considerable and tilted towards the downside.” Although the war is taking its toll, the “mini budget” in September and ensuing political turmoil only exacerbated the situation. The £45 billion package of unfunded tax cuts wreaked havoc on UK markets and sterling, toppling the 44-day premiership of Liz Truss. Successor, Rishi Sunak and Chancellor, Jeremy Hunt are trying to steady the ship, but the jury is out as to their success.
Against this backdrop, careful analysis and research will be crucial. “While we are seeing the Ukraine war, inflation, interest rate rises and political chaos, it’s important to remember that, prior to this, we had the chaotic Trump years, coronavirus, lockdowns, the great financial crises, September 11th and so on,” Lennie Shaw, equity dealer in the HL fund administration & development team at Hargreaves Lansdown.
“The fact is there’s always been something for the markets to worry about. The trick is finding companies and investments that are robust enough in their balance sheets to make it through difficult, turbulent markets when others fall by the wayside.
He notes that “playing the long game is important when recognising quality companies whose share price will bounce back when the market wakes up to the fact that a stock that has been ‘beaten up’ by algorithmic selling is now looking very cheap. The snapbacks can be vicious when that happens. Hardly anyone ever buys right at the bottom of the market.”
