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Investing amid geopolitical storm clouds

8 May 2017 10:51 am - 0     - {{hitsCtrl.values.hits}}

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By Manpreet Gill
Geopolitics has always posed a tricky challenge for investors. In the perennial tussle between greed and fear, heightened concerns about a likely geopolitical event often leads investors to turn defensive or even ‘flee’ the markets. However, recent unexpected geopolitical events such as Brexit and US President Trump’s election have shown that ‘turning defensive’ has not always helped investment returns, particularly when financial markets seem to either underwhelm in their reaction to a seemingly major event or react in a completely unexpected manner. 
History, luckily, does offer some evidence that can help with a few broad conclusions. First, most conflicts seem to have only short-lived impacts on financial markets. One needs to look no further than the South Korean equity market index for an example of how a long history of North Korean sabre-rattling has only ended up creating buying opportunities in the 
equity market. 
Second, a more permanent market impact seems to take place only when there is a lasting impact on the fundamentals of an asset class. The 1970s oil embargo was a good example of this, where a geopolitical event (OPEC’s decision to reduce supplies) made a lasting change to the supply-demand balance of oil, sending prices higher for a sustained period of time. 
Finally, there is some evidence of ‘sell-the-rumour-buy-the-fact’, though seasoned investors will recognize this impact is not limited to geopolitical events alone.
Today, we believe there are three geopolitical risks that investors should factor into their calculus – Euro area politics, ongoing concerns of restrictive trade policy in the US and the risk of escalation of tensions on the Korean peninsula.
Euro area equities are now amongst our most preferred asset classes globally, together with the EUR and high- yield bonds (in both the Euro area and the US), based at least partly on what we see to be receding political risk this year. Financial markets started 2017 with the worry that an upset win by a Eurosceptic party in the Dutch, French or German elections this year could trigger renewed worries about the future of the Euro area and lead to severe losses in European equity markets and the single currency.
However, the election outcomes have proven otherwise, with pro-EU parties winning the Dutch elections and appearing to be on course to win the French presidential and parliamentary elections. None of the major candidates of the German election later this year is likely to pose a risk to the European Union’s future. Thus, for 2017, it appears geopolitical risk from European politics is likely to abate, barring an external surprise. This is part of the reason why we prefer Euro area assets. The Italian election in 2018 could well cause more worries, based on current opinion polls, but we believe it is too soon to conclusively price in concerns on 
this front.
Trade tensions are a key risk, more so for emerging markets, including Asia, given their reliance on exports as a key driver of economic growth. US President Trump’s initial rhetoric has given way to a more pragmatic outlook, which has arguably helped in the continued rebound in emerging market equities, bonds and currencies. 
However, we do not believe trade tensions are likely to go away – the recent US tax on Canadian lumber imports and comments regarding NAFTA remind us that policy risk for open, export-oriented economies has not permanently disappeared. Our approach has been to favour domestic-oriented markets like Chinese equities (where we like ‘new economy’ sectors, which benefit from the Chinese consumer) and Indian equities (where exports remain relatively small as a share of gross domestic product (GDP)) within our broader preference for Asia ex-Japan equity markets.
Tensions surrounding North Korea, though, could pose the biggest challenge. Historically, sabre-rattling by the North has led to only a temporary increase in market volatility and, for South Korean equities at least, has ended up creating a relatively short-lived buying opportunity. However, a more nationalist US leadership and North Korean efforts to firmly cross the inter-continental ballistic missile threshold suggest a higher-than-usual risk of escalation.
For an investor, this last risk remains much more difficult to mitigate, particularly given its potential to cause longer-lasting market damage. A simple approach could be to focus on traditional safe-havens like gold or high quality bonds. However, we believe a broader approach of constructing a diversified investment allocation that includes a mix of assets that should do well in a range of scenarios (in this case, the scenario that the crisis passes or the alternative scenario of escalation) may be superior, particularly given how difficult it is to predict the final outcome.
We always believe fundamentals and a sensible asset allocation approach sit at the heart of good investment decision-making. Geopolitics should not overwhelm that thought process, in our view, but instead add an additional factor to consider when making investment choices. We believe our investment case for favouring Euro area equities globally and China and India within Asia ex-Japan, is not only valid on its own fundamental grounds, but also consistent when we add geopolitical risks into the mix. 
(Manpreet Gill is Head of Fixed Income, Currency and Commodities Strategy at Standard Chartered 
Private Bank)

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