Welcome to Finance and Fury. In this episode we will be looking at geopolitical risks and equity portfolios.

Geopolitical risks are nothing new – these are always going on and equity markets are always looking at geopolitical risks – and how it will impact the price of assets – in this episode we will be looking at how certain events impact asset pricing, and how to help mitigate any risks

The definition of geopolitics is “the study of how geography influences the international policies of nations and societies”

One of the main geopolitical risks markets have seen over the last 12 months is Russia and Ukraine – But this is not the only geopolitical risk going on that could impact markets – trade tensions between China and the US

  1. While a virus is not strictly a geopolitical issue, the policies that flow from it, such as lockdowns and travel bans, are.
  2. While geopolitical issues are often very concerning to those living through them, they may or may not have a significant impact on the price of equities
  3. most coverage of geopolitical risks will focus on the narrative – who are the good guys, who are the villains, when only looking at investments, you need to quantify the risks involved and determine if the issue passes the ‘so what?’ test
    1. For any geopolitical event to directly affect a particular equity investment over the long term, it must impact the cash flows of that business, or one of the other components of valuation, namely risk premium, interest rates or inflation
    2. This doesn’t mean that investments won’t decline in value in the short term – panic selling will always occur, but this can be buying opportunities

To start breaking this down – look at the sources of geopolitical risk – There are many different sources of geopolitical risk – wars and conflicts, disruption of free trade, government policies known as political risk – many of these issues can then have flow-on effects to economic factors such as inflation, economic growth and interest rates – but also to individual assets that make up a share market  

  1. Wars and conflict – including terrorism are some of the first issues that spring to mind when considering geopolitical risks.
    1. The impact from this can range from a simple regional issue, right through to a world war
    2. The impact will also depend on the countries involved and their significance to the world economy and trade
    3. As an example, right now – Russia produces 17% of the world’s gas and 13% of its oil. It also supplies 15% of traded coal. Both Russia and Ukraine are major exporters of grain and fertiliser where Ukraine is estimated to have fed 400 million people in 2021. Russia is forecast to harvest 130 million tons of grain this year, but many countries are declining to deal with Russia and even if they wanted to, more are unable to do so due to financial sanctions.
      1. This is leading to rising prices and the threat of significant food insecurity across North Africa and Asia – but Egypt and Indonesia in particular – rising energy prices and food insecurity could even lead to civil unrest in these countries – like the last time wheat prices rose significantly, this was a contributing factor to the Arab Spring event
    4. Future potential conflicts – China and Taiwan, along with China’s trade tensions with the US, Australia and some other nations
      1. spill over effects from further restrictions on trade between say Australia and China would impact value chains of our export markets, particularly iron ore and coal
      2. Over the last 40 years, consumers and companies have benefited as the world embraced more efficient supply chains through free trade – companies tend to make their own decisions about supply chains, but those decisions are either facilitated or hampered by geopolitical factors
  • But the era of free trade agreements from the 90s to now seems to be coming undone – we are also seeing some disruptions to global food supplies all leading to acute shortages of some essentials like wheat and rice in some countries – in turn, many countries are introducing protectionist policies to protect their domestic supplies first – India has just banned the export of wheat. Indonesia has banned the export of palm oil
  1. Global Monetary policy – this creates major geopolitical fallouts – While inflation itself is not a geopolitical risk, how countries and central banks choose to respond to it is through their interest rate policies
    1. Inflation has risen to the highest level in decades in many Western economies – Central banks are responding by tightening monetary policy and increasing interest rates – This has a major direct impact on equity valuations. Actions of central banks impact bond markets, which in turn impact equities.
  2. Other geopolitical risks – i.e. tail risk events, meaning likelihood of them occurring is low but if they were to occur the impact could be very significant.
    1. Strict government policies – such as China’s zero COVID policy – implementing harsh lockdowns has led to severe disruption of supply chains – when companies have no employees to work, or nobody to sell a product to, it impacts that bottom line
    2. Expropriation of assets – act of a government claiming privately owned property against the wishes of the owners – This has occurred in many African nations over the last few decades, but did occur in the US in 1952 when the Truman Admin expropriated 88 steel production facilities – when a company loses their production capacity, it reduces their capacity to generate revenues, hence their FCF declines

Impact on equity investments – To determine the impact of a geopolitical event on equity investments, it requires an understanding of which events are important and which ones are just noise

  1. As previously mentioned, you could call this the ‘so what?’ test
    1. A lot of the analysis of geopolitical events revolves around creating a narrative – which will often focus on politics and predictions of future events – but this often does not provide any answers on how it will impact investments
    2. Look at some past major events that received a lot of media attention at the time – The US was involved in the conflict in Afghanistan for 20 years – but from the perspective of the share market, it was basically irrelevant. Likewise, the war in Iraq, only had a minimal impact on investments when it commenced in 2003 despite enduring for eight years – it is important to cut through the narrative and seek to quantify the impact that specific events are likely to have on investments – the nature of the impact will always depend on the type of event
  2. The impact of geopolitical risks on equities ultimately comes down to the impact on valuations – when trying to work this out, remember that valuations are normally determined by four factors
    1. Future cash flows – this is the expected cashflow that a company will generate in present value
    2. Interest rates and inflation – this impacts the cost of capital along with the discounting of the free cashflow to get the present value of future earnings
    3. The risk premium – this is the representation of the compensation that investors require in the form of additional returns for making investments that pose a higher level of risk – i.e. the higher the risk, the higher the premium
      1. an increase in the risk premium is normally only a short-term effect as once the risk has been digested by the market, the effect starts to disappear, usually after about six months
    4. The volatility in financial markets associated with geopolitical events is a function of this risk premium effect – meaning that markets are often very volatile around geopolitical events, but in most cases the long-term impact has been minimal.
  3. Let’s look at a few studies:
    1. The first looks at the impact on markets over the course of 12 significant geopolitical events, war and terrorism related over the last 40 years shows surprising results. The median return of the All Ordinaries Index was -2.0% with a positive return 50% of the time as measured during and immediately after the time of the conflict. The median return of the S&P 500 Index was 2.1% with a positive return 75% of the time. Gold and bonds are often viewed as hedging instruments, or safe havens, in times of uncertainty. But Gold and 10-year US Government Bonds both had negative median returns, with a positive return for bonds 50% of the time and only 42% of the time for gold. Equities were both more profitable and safer over the period of these events
    2. in early 2003, when the US invaded Iraq, the S&P 500 rose by 14.6%, whereas gold fell by 0.9%.
    3. Looking at a study of the effect of geopolitical events on the S&P 500 over 22 separate events – dating back to the Japanese attacks on Pearl Harbor in December 1941 – in the, US shares declined on average by 4.6%, but recovered those losses in only 43 days
    4. A separate study of the US Dow Jones Index over the course of 29 events dating back to Germany defeating France in 1940, found that it took only 18 days from the beginning of the crisis for the share market to bottom out with an average decline of 11.6%. 86% of the time, the benchmark had rebounded to be 7.6% higher one month later. Twelve months later, on average, the market was 24.7% higher from their low point
  4. Separating the market to underlying share exposures – When looking at a portfolio of direct equities, it is important to understand the underlying exposures of each business.
    1. Will a trade war result in tariffs on a company’s products? If you only have one investment on the ASX, such as Fortescue, and China bans all imports for iron ore – it is likely that the price of this asset will tank – This is the risk of individual holdings – as investors will not always be aware of the finer details of a firm’s operations as the level of disclosure varies. It can be difficult to piece together supply chains, vendors, debtors etc.
  5. This is why this data is looking at the index in general – certain types of companies will suffer more than others through geopolitical events – but the index helps to negate these risks
  6. The good news – Geopolitical events and the volatility that follows can provide buying opportunities for those able to look through the noise and take a long-term view
    1. For a geopolitical event to have a longer-term impact, it must impact one of the other components of valuation, being future cash flows, inflation or the risk-free interest rate – normally markets can decline due to uncertainty – but once the fog of war clears, positive returns return as long as the key components of valuation aren’t impacted significantly
      1. This will lead to permanent changes in the cash flows of certain businesses resulting in a permanent change in valuation. Low confidence and high inflation may force consumers to cut back, which creates a negative feedback loop as company profits are reduced, forcing them to reduce staff – then economic growth declines and unemployment increases.
      2. This is what happened with the oil shock of the 1970s and with recent inflation, central banks lifting interest rates has impacted asset valuation and could push economies into recession
    2. Risk mitigation strategies – One option to avoid risk is to reduce any allocation to equities and hedge with gold or bonds
      1. But remember – one study referred to earlier that looked at 12 significant geopolitical events over the last 40 years, found that contrary to common perception, neither gold nor bonds produced better returns than equities during the geopolitical events. The average return from gold was 0.7% but this was highly unpredictable. The returns ranged from -34% to +27%, with a median return of -0.9%. It only provided a positive return 42% of the time, so as a hedge it was ineffective – Government Bonds were also ineffective as a hedge. The average change in yield was 0.391%, meaning that bond prices fell on average.
        1. Remember that Bonds are negatively correlated with inflation, and inflation often increases in times of war or other geopolitical events – Governments may also increase their borrowing during times of war, which pushes bond yields up and prices down.
      2. What about holding cash – or shifting assets to a safe haven currency like the US dollar?
        1. This strategy was a bit more successful than gold or bonds, but only produced a positive return 58% of the time, for an average return of only 0.3%
      3. Probably the most effective way to manage the risks to a portfolio associated with a geopolitical event is by looking at the specific exposures. This is more applicable to a direct equities portfolio rather than managed funds or ETFs – but this can be very time consuming and require a deep dive into assets
    3. Summary – the investment climate will always be filled with concern regarding the impact of geopolitical events. The current geopolitical risks include the war in Ukraine escalating, trade tensions, especially with China
      1. From the perspective of an equity investor, it is essential to distil the risks from a geopolitical event down to the potential quantifiable risk on a portfolio.
      2. Many studies have shown that while an unfolding geopolitical event often has a sharp short-term impact on equities, taking a long-term perspective the impact is barely discernible.
        1. some studies have shown that equities have performed better during times of war. It is important to break down how a particular event will impact a particular company by looking at the components of valuation.
        2. Trying to mitigate against geopolitical risks has also proven to be ineffective and is arguably unnecessary. Conventional safe haven alternatives like gold and bonds have performed worse than equities. Again, the best way to mitigate the risk is to have a clear understanding of the exposures of each underlying investment.
      3. If markets do go down – ask yourself if one of the valuation factors will be impacted, being FCF, interest rates, inflation or the risk premium – if yes, then markets may be justified in their decline – if not, then a downturn in asset price could represent a buying opportunity

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