Special Report, Outlook 2015: A year of eerie calm
According to research from Citigroup, the world is 54% more geopolitically active today than it was before the financial crisis. The yearly average number of elections, government collapses and mass protests has risen to 21.7 since 2011, from 14.1 for the preceding decade.
In the past year alone there has been the first shutdown of the US Federal Government in 17 years, a revolution in Ukraine and the annexation of part of its territory, the imposition of sanctions on and by Russia, the 50-day Israel-Gaza war, the continuation of Syria’s civil war, the rise of Islamic State – and even the threatened breakup of the UK.
“We have seen not one or two geopolitical events, but many,” says Kerry Craig, a global market strategist at JP Morgan Asset Management. “This year alone, nearly 30% of emerging markets’ GDP has been subject to an election, for example. At the start of October a number of events hit markets at the same time which, on aggregate, looked quite scary, especially in the context of a fragile economic environment where the euro-zone could slip into recession. The ripple effect meant the geopolitical landscape had a bigger impact.”
And yet, periods of volatility have been short-lived and, in general, equity markets have had a strong year, only temporarily giving back some gains between mid-September and mid-October on concerns of slowing global growth, exacerbated by the West African Ebola outbreak and political protests in Hong Kong.
Over the past few years, market volatility has largely remained well below long-term averages. According to an analysis by AXA Investment Managers of daily returns for US equities between 25 August 1999 and 24 Septmeber 2014, long-term annualised volatility was 20.3%. However, since ECB president Mario Draghi declared the central bank would do “whatever it takes” to save the euro, annualised volatility has been just 10.8%. Global equity volatility has also been roughly half the long-term average.
“For the most part, volatility has been contained in time and size when geopolitical risks have risen,” observes Monica Defend, head of global asset allocation research at Pioneer Investments. “Financial markets have remained resilient and investor’s reaction has been muted.”
One of the main reasons for the relative calm has been the liquidity injected by central banks into the system in order to preserve price stability.
At a glance
• Rising geopolitical tensions are not translating into rising financial market volatility.
• This is partly thanks to volatility-dampening central bank intervention, the changed nature of geopolitical risk, and the lack of specific transmission routes into the financial system.
• Political, trading and financial interconnectedness may look like transmission routes, but currently act as brakes on geopolitical brinkmanship.
• Faster global communication and new financial instruments have also helped markets respond to geopolitical news more quickly and smoothly.
• The one element likely to change soon is central bank intervention – geopolitical sensitivity in investment portfolios could rise as liquidity is withdrawn.
“Investors appear happy to allow the central banks to keep the money flowing while they focus their worry on the fragility of the economic path rather than on geopolitical risk,” Defend explains.
As well as the unprecedented intervention by central banks, the nature of geopolitical events has changed considerably from what was experienced during the Cold War. Back then, geopolitical tensions were initially focused around the two major powers, the US and the Soviet Union. Since the collapse of the Soviet Union, however, geopolitical tensions have been more localised.
“It is safe to say that the world is more geopolitically active today than for many years,” says Marcus Svedberg, chief economist at East Capital. “But we are still far away from the situation that characterised the Cold War period. For one, the economic integration between East and West is dramatically different today than it was during the Cold War, and this matters.”
Even though today’s world is much more interconnected through trade links, capital flows and politics, the extent to which geopolitical tensions are able to affect global markets appears to be limited. Generally, as long as there is no transmission channel into the broader global economy, geopolitical risks are typically idiosyncratic and localised, impacting only markets in the affected country or region. Ebola and the conflict in Syria are two such examples. However, where there is an appropriate transmission channel, such as commodity or banking prices, the impact can be felt more acutely by investors.
Russia is an interesting example. Even as tensions mount between Russia, the EU and the US, the investment-portfolio impact has been relatively localised.
“Russia has very much traded on geopolitical newsflow this year,” Svedberg reports. “Both the currency and the equity market have moved in line with escalation and de-escalation in Ukraine.”
The impact has been felt by investment markets locally and regionally. As at 30 September, for example, Russian stocks accounted for over 68% of the MSCI Emerging Markets Eastern Europe index. Seven of the 10 largest holdings in the index are Russian companies, including Gazprom, Lukoil, Sberbank of Russia and Norilsk Nickel. The index was down 22% for the year to 27 October.
Moving marginally further afield, Austria’s Raiffeisen Bank International, which has the greatest exposure to Russia among the western lenders, saw shares fall over 10% on 23 September after it warned it would double provisions for bad loans to 30% this year because of the Ukraine conflict, dragging the firm to a full-year loss.
On a global scale, however, the impact is less keenly felt.
“The question is how much Russia impacts the outlook for the US, the west, oil supply or interest rates,” according to Markus Schomer, chief economist at Pinebridge Investments. “The answer is not that much.”
Contrast these decidedly global events with the very regional US housing market crash that resulted in the 2007-09 global financial crisis. The latter had such a devastating financial impact because it was able to transmit through the banking system on a much greater scale.
“Many people didn’t realise how many banks were exposed to the US housing market,” Schomer says. “European banks were even harder hit than US firms. The global banking channel transmitted a regional crisis around the world.”
Oil is another very significant transmission channel, as was demonstrated by the first Iraq war, which had a dramatic impact on global oil supply. Average monthly prices of oil rose from $17/bbl in July 1990 to $36/bbl in October that year, which was a significant factor in the global recession of the early 1990s.
“Oil is a key variable,” Pioneer’s Defend says. “Its tensions fuels volatility in the financial markets as its price movements affect the real economy. When they lift, they erode corporate margins and consumption. When they go down they create negative consumer price dynamics, one of the factors behind the increasing deflation fear in Europe.”
Although Russia is a significant commodity provider, the interdependent nature of trade and politics between Russia and the West acts to prevent the situation transmitting through to the broader economy through oil prices, thereby containing the impact on investors’ portfolios.
“Russia produced 13% of all the oil produced in the world in 2013, according to the BP Statistical Review, so it would certainly make a big difference if Russia were suddenly to stop producing,” according to Andrew Kenningham, senior international economist at Capital Economics. “The chances of something happening that is big enough to stop Russia exporting oil is very small. Both sides have very strong incentives to keep the oil flowing and the way sanctions are being used shows the aim is to tighten the screws without imposing too much damage on Russia’s economy or those of its trading partners. The West clearly wants Russia around the table and Russia is clearly keen to stay there.”
Another reason why Russia and many of the other geopolitical events in recent years have had a limited and short-lived impact on markets is the pro-active risk management that has become central to investment portfolios. Effectively this means investors become less sensitive to geopolitical events over time. Markets are quick to adjust to changes in the geopolitical landscape and the level of information available has increased dramatically, all of which allows investors to price-in risk fairly quickly as a situation develops.
“What is different today is the way that equity markets are behaving and the level of information efficiency which has gradually increased over the last few decades,” argues Alexei Jourovski, head of equity at Unigestion. “We have also seen the emergence of new tradable instruments and new asset classes such as volatility. Emerging equity markets have also become more liquid. Overall, today we are living in a world that is more global and reacts more quickly to information with more tradable instruments for this information to be reflected in the price of financial assets.”
The risks arising from events in Syria, the Ukraine or the rise of Islamic State have been present for some time and markets have been able to adjust accordingly. The same can be said for the risks the Ukraine situation poses to Germany in particular, and Europe in general, which relies on the region for its energy supplies.
“I do not see this as a driving force for pro-active risk, as it has largely been priced in, unless the situation there escalates further,” Jourovski says. “The Islamic State has had an impact but this negative geopolitical event has been priced into the equities that have links to the areas where the Islamic State has been active. The democracy movement in Hong Kong has seen some volatility but the impact will be limited and not seen as a major risk.”
The volatility surrounding recent geopolitical events has undoubtedly also been dampened by the massive central bank expansion seen around the world. However, with the Federal Reserve and Bank of England expected to begin withdrawing support and start raising interest rates over the next year, markets’ sensitivity to geopolitical risks could increase.
“This is a top-ranking issue on our wall of worry,” says Pioneer’s Defend. “In preparation for this, we have sought to build some protection in our asset allocation, for example, by hedging the main risks to the scenario. We believe this decision will help to mitigate the effects of geopolitical risks.”
For many investors, however, the idiosyncratic nature of many of today’s geopolitical risks require little measures beyond those already in place to address wider risks in their portfolios.
“Country risks tend to be diversified away, especially in large passive portfolios,” explains Stefan Dunatov, CIO at Coal Pension Trustees. “By definition, when an investor diversifies country risk, they are diversifying political risk. That is how most people do it. However, I’m not sure if investors are really capable of making a call to deliberately diversify away political risk in a concentrated portfolio. It doesn’t make sense for investors to try and second guess the political elite, and economic and political shocks are very difficult to predict.”
Others emphasise the long-term nature of institutional investment and the dangers of tactically allocating around these events.
“Ebola is like the SARS scare a few years back, and Ukraine and ISIS are in areas that are currently peripheral to main capital market concerns,” says Bob Maynard, CIO at the Public Employee Retirement System of Idaho (PERSI). “The problem with tactical asset allocation around these issues is that it isn’t just one decision that has to be right, but three: when to get out of an area; when to get in; and what to do with the money in the meantime. Even if each call is right, the timing of the decision and its impact has to be correct as well.”
Perhaps the conundrum with which we opened this article is not such a conundrum, after all. Geopolitical activity has certainly risen significantly, but its impact has become increasingly idiosyncratic, localised and often short-lived since the end of the Cold War as markets have become quicker to adjust and price the associated risk accordingly. That price – like all market prices – may have been distorted recently due to the counter-effect of quantitative easing on volatility, and with that intervention nearing an end investors may see an increase in markets’ sensitivity to geopolitics. However, whether investors can and should adjust portfolios in anticipation of these risks remains open to question.
As PERSI’s Maynard says: “Much of the geopolitical world today is transitory and currently peripheral to economic or capital market concerns.”