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What the Return of Middle East Tensions Could Mean for Markets

January 2020 
By Philip Haddon

Markets are once again in thrall to geopolitics following recent events in the Middle East. Our research shows what such periods can mean for investment performance.

Insight from our sub-adviser, Schroder Investment Management
Philip Haddon
Head of Investment Communications


Last week’s killing of Qassem Soleimani, the head of the Iranian Revolutionary Guards’ overseas forces, has reignited tensions in the Middle East and sent tremors through asset markets.

The price of oil rose sharply to more than $70 a barrel amid concerns that tensions in the region will impact supply.

Meanwhile, the value of assets perceived as “safe havens” such as gold, the Japanese yen, and US Treasuries, had also risen. Indeed, the price of gold at one point on January 6 hit its highest level since April 2013 ($1,580 per troy ounce).

Last year, our economists published research into the impact of geopolitics on markets. They found that it can significantly impact investment returns and that an active investment approach can help navigate turbulent times.

 

In summary:

How does geopolitical risk affect markets?

Geopolitical risk can refer to a wide range of issues, from military conflict to climate change and Brexit. We look at it as 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.

Heightened geopolitical risk tends to trigger investors to move away from riskier assets such as shares and towards perceived “safe” assets.

This negatively impacts stock market returns, while government bonds benefit (particularly those with short maturities as they are perceived as the safest).

Geographically, investors also shift their money away from perceived riskier regions such as emerging markets (EM) and toward developed markets such as the US.

This is illustrated below, by the performance of four different assets (US shares, global shares, gold, and US government bonds) during three major geopolitical events.


Figure 1:

Cumulative return percentages in reaction to geopolitical event %

WP518-Figure1

Source: Thomson Datastream, Schroders Economics Group. 5/14/19. Past performance does not guarantee future results. S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks. The MSCI World Index captures large and mid cap representation across 23 Developed Market countries. S&P GSCI Gold Index, a sub-index of the S&P GSCI, provides investors with a reliable and publicly available benchmark tracking the COMEX gold future. US 10-year Treasury bonds are U.S. government debt securities with a maturity of 10 years and which are marketable and set at a fixed interest rate.

 

How did our analysis work?

Our economists, Keith Wade and Irene Lauro, looked at five different periods of heightened geopolitical risk since 1985.

Their research relied upon the Geopolitical Risk Index (GPR), which reflects automated text search results of the electronic archives of 11 national and international newspapers. It captures the number of mentions of key words such as “military tensions,” “wars,” and “terrorist threats.”

Periods of geopolitical risk were defined as time intervals that saw the index rise above the 100 mark, as seen in Figure 2.

Our economists created a “safe” and a “risky” investment portfolio and compared their performances during these periods.1

Of course, no investments are truly “safe” or risk-free. Investment values go up and down and you don’t always get back the amount you originally invested.

We use the term “safe” merely to distinguish between the relative stability of assets such as US government bonds (which the US government is highly unlikely to default on), versus shares, which are relatively “risky” (companies regularly go bust). We could equally have called them “less volatile” and “more volatile” portfolios.

 

Figure 2:

Geopolitcal Risk: step change after 9/11

WP518-Figure2

Source: “Measuring Geopolitical Risk” by Daria Caldara and Matteo Iacoviello at https://www2.bc.edu/matteo-iacoviello/gpr.htm. Schroders calculations and annotations, 4/11/19

 

What did our analysis show?

Our analysis shows that in the short-term the portfolio of “safe” assets delivers higher returns than the risky portfolio in three out of the five periods considered.

We also looked at how a diversified “60/40” portfolio (60% “risky” assets and 40% “safe” assets) compared. We found that it performed worse than the “safe” portfolio.

 

Figure 3:

Safe assets outperformed risky assets 3 out of 5 times

  Safe Portfolio Risky Portfolio 60/40 Portfolio
Period of heightened political risk Length Return (Total change %) Return (Total change %) Return (Total change %)
1) Gulf War
(Aug 1990-Feb 1991)
7 months 8.2 -6.3 -0.5
2) 9/11 and Iraq Invasion
(Sep 2001-Jun 2003)
22 months 18.4 -16.0 -2.2
3) Madrid and Moscow bombings
(Mar-Oct 2004)
7 months 2.0 -0.9 0.3
4) Crimea and ISIS
(May 2014-Few 2015)
6 months 1.8 4.0 3.1
5) North Korea - Trump
(Aug 2017-Jan 2019)
18 months 0.7 1.6 1.2

Source: Schroders, July 2019. Table above is for illustrative purposes only and should not be taken as a recommendation to adopt an investment strategy. Past performance does not guarantee future results. Investors cannot directly invest in an index.

 

What if you wait until after the geopolitical risk subsides?

The results were particularly interesting when our economists extended their analysis to six months after the GPR index falls back below 100. This enabled them to get a better idea of how an investor would have performed if they had held onto their “risky” portfolio through the turbulence and then allowed markets to recover their poise.

They found that over the extended time period, the “risky” portfolio outperformed the “safe” portfolio in four of the five periods (the exception being 9/11 and the Iraq invasion). The “risky” portfolio, also scored better than the “safe” portfolio in each of these four periods.

However, an investor would have had to withstand considerable volatility to realize the benefits of the “risky” portfolio so we threw into the mix a “dynamic” portfolio. This would involve an investor implementing a “safe” portfolio as soon as tensions start to rise (the GPR goes above 100) and switching to the “risky” portfolio when they dissipate (goes back under 100).

For an individual investor, this would likely not be practical with their own portfolios. However, it may be prudent to entrust their portfolios to an active fund manager who takes geopolitical risk into account.

This dynamic portfolio did well, delivering a higher total return than the “risky” portfolio in three out of the five periods and higher than the “safe” portfolio in four out of the five periods. The analysis showed that active fund managers can potentially avoid some of the losses and still enjoy much of the benefits from taking geopolitical risk into account.

Talk to your financial advisor to make sure
you're positioned for geopolitical risk.



1 The safe portfolio allocates 50% to the US 10-year benchmark government bond, with the rest equally distributed among gold, Swiss franc, and Japanese yen. The risky portfolio comprises 50% in the S&P 500 Index, the rest allocated evenly between the MSCI World Index and MSCI Emerging Markets Index. After 2007, we also include a basket of local EM sovereign debt made up of local currency sovereign bonds of Turkey, Brazil, Mexico, Russia, and South Africa.

Important Risks: Investing involves risk, including the possible loss of principal. • Foreign investments may be more volatile and less liquid than US investments and are subject to the risk of currency fluctuations and adverse political and economic developments. These risks may be greater for investments in emerging markets. • Small- and mid-cap securities can have greater risks and volatility than large-cap securities. • Commodities may be more volatile than investments in traditional securities.

The views expressed herein are those of Schroders Investment Management (Schroders), are for informational purposes only, and are subject to change based on prevailing market, economic, and other conditions. The views expressed may not reflect the opinions of Hartford Funds or any other sub-adviser to our funds. They should not be construed as research or investment advice nor should they be considered an offer or solicitation to buy or sell any security. This information is current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Schroders or Hartford Funds.

Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent.

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