• How investment markets react at times of global political instability
  • US and European investors take a risk-off approach during periods of political turmoil
  • It is too early to tell how the Afghanistan withdrawal will play out

The evacuation of US and coalition troops and civilians from Afghanistan and the Taliban takeover in August prompted us to examine other episodes of regime change and how equity markets reacted. 

Markets track and react to what is dominating the news agenda. The Afghanistan pull-out that began in February 2020 and concluded on 30 August 2021 fuelled global media attention. It also influenced asset allocation decisions for retail and institutional investors. 

We looked at the lessons from three big regime changes over 30 years: the collapse of the Soviet Union, the Kosovo War and the Arab Spring. 

We found that, during the transition of power over a six to 19-month period: 

• Defensive stocks, specifically the quality sub-factor (high gross profits to assets) tend to outperform; 
• Risk-on stocks, notably small cap and high volatility, underperform; 
• US and European investors take a risk-off approach during periods of global political turmoil. 

The periods included the six months from August 1991 to January 1992 during the collapse of the Soviet Union; the 14 months from May 1998 to June 1999 in the Kosovo War, and the 19 months from January 2011 to July 2012 during the Arab Spring.  

Monthly factor returns compared with the wider market

In the US and Europe, high gross profits to assets (the quality sub-factor as defined above) stood out for outperformance, and high volatility and small cap for underperformance. Figure 1 shows average monthly returns in these periods, compared with the wider market.

Across these periods, several quality sub-factors did well. In the US, the average month return for quality was 22bps. In Europe it was 13bps. For volatility, the average month return in the US was -13bps and in Europe it was -2bps. High-volatility stocks during the Kosovo War first lost ground and then recovered. If the Kosovo War is ignored, European high-volatility stocks lost about 25bps per month during the collapse of the USSR and the Arab Spring. When it comes to small cap, US average month returns decreased by 18bps and Europe dropped by 20bps. 

However, the standout measure was high gross profits to assets, which consistently generates above-market returns over long periods of time. The underperformance of high-volatility and small-cap stocks during such periods is understandable: investors move away from higher risk investments during periods of uncertainty. Examples of high-quality stocks are UPS and SAP, while the ranks of low-volatility large-cap stocks include Nestlé and Microsoft. Examples of high-volatility stocks are Airbus and Disney.

Figure 2 shows how each of these sub-factors performed throughout each of the periods we examined.

When it comes to emerging markets, we should not expect them to react in the same way as US and European markets. The performance of factors in emerging markets differs from US and European counterparts almost 90% of the time. 

What about value and growth? 
We can expect quality stocks to outperform long term, but when it comes to value and growth the story is more mixed. A regime change or transition of power does not cause notable outperformance from value or growth. However, the rising-interest-rate environment that we find ourselves in does have an impact. 

Rising interest rates have traditionally provided a boost to value stocks but our research has found that value will only outperform long term if rates rise quickly enough. In the US that means the 10-year rate rising more than 5% in one month and in the UK the minimum rate is around 20%. Rising interest rates will also contribute to a growing risk-off mentality, which will be a boost to larger-cap stocks. By the same token, smaller-cap stocks, that often carry more risk for investors, will likely underperform.

Q3 factor performance 
In terms of timing, over the periods in question it took several months for these impacts to materialise. This means it is still too early to tell how the Afghanistan withdrawal will play out. We tracked the performance of factors over the third quarter of 2021, which coincided with the withdrawal process and the first few weeks of Taliban control. 

The US saw outperformance of quality, large-cap and low-volatility stocks. This indicates a continued preference for defensive stocks. Momentum stocks also showed outperformance over the quarter. Recently these stocks have been tied to quality stocks more than either value or growth, since quality stocks have had more consistent positive performance (momentum) than value and growth which have continued to move back and forth. 

Regime change impact on US markets

Across the quarter, the value/growth seesaw continued. Value was market-like in July, lost in August and gained in September. Growth was market-like in July, gained in August and was mixed in September. Quality achieved mixed performance in September, but we expect to see this improve in the coming months. 

In Europe, stability-quality measures outperformed while quality profit and leverage measures underperformed or tracked the market. Value was down, and growth was up until September when value outperformed and growth lagged the market by about 70bps (except for forecast growth, which outperformed by 70bps in September). UK interest rates rose for the quarter, but especially in September when they went from 0.6% to 1%. This rise is consistent with value’s outperformance in September. Like in the US, value’s outperformance was not enough to turn the entire quarter in value’s favour. 

At the time of writing, the political situation is still in a state of flux and the humanitarian crisis in Afghanistan is deteriorating. In response to geopolitical conditions such as these, investors in Europe and the US tend to become more risk averse. There are also other headwinds in play, such as the spectre of rising interest rates. Longer term, it would not be surprising to see similarly defensive investment choices, supporting quality and suppressing risk-on decisions. When it comes to value and growth, it’s interest rates that will decide. 

Damian Handzy is head of research and applied analytics at Investment Metrics and James Monroe is senior consultant