Short and Sharp: Resist the temptation to trade geopolitical risk

Last week’s escalating tensions surrounding North Korea immediately affected markets. Global equities fell almost 2%, bond yields fell, credit spreads widened meaningfully, and the U.S. dollar and gold strengthened as investors went into flight-to-quality mode. The VIX, a measure of the expected turbulence of U.S. stocks implied in the price of options, reacted as well. This “fear gauge” jumped 70% over three days to its highest level since the U.S. presidential election.

But take a deep breath – while this is a significant move by recent standards, it can hardly be considered a sign of outright panic. Consider South Korea’s stock market (the Kospi index). Given its proximity to the situation, it was among the worst affected. It fell by just over 1%; though, the Kospi’s worst day in 2017 was in July, moved lower by a global retreat in tech stocks. But even as the saber rattling continues, most markets have swiftly recovered in the past few days. The Kospi index is around 15% higher year to date.

This reaction may be difficult to comprehend. After all, the risks associated with global conflict can’t be exaggerated. But then perhaps the small market reaction simply reflects the fact that the market struggles to price in the consequences of such events.

But in fact, for investors, not overreacting to escalating tensions has been the correct strategy over recent years. Geopolitical tensions have tended to result in diplomatic talks (the kind we have seen in recent days), so investors have been better off to focus on the economic and value drivers of market performance, while maybe even spotting some buying opportunities.

So what should investors be considering? Equity and credit market valuations are stretched, particularly credit. Importantly, volatility has been lingering at unusually low levels. The combination of tight valuations and subdued volatility means that markets are vulnerable to shifts in sentiment. Prolonged geopolitical uncertainty – say in North Korea – may be a catalyst for a greater pullback.

Current fundamentals, however, support extending the equity and credit market cycles. The synchronized global recovery is coasting along with little sign of overheating, and subdued inflationary pressures are providing flexibility for central bankers to gradually tighten monetary policy. The growth and policy outlook supports a continued positive earnings picture.

So, while military escalation could disrupt markets and perhaps trigger a greater pullback, recent history would tell us that there should be little lasting impact. If my portfolio had large exposure to assets that would perform extremely poorly in the event of intensifying North Korean tensions, I would maybe consider hedging strategies, such as increasing allocations to the U.S. dollar, U.S. Treasurys, and gold. But ultimately, any sell-off would likely be short-lived, and investors should instead look for good entry points.

Last week, financial markets were down marginally and I would simply class that as a dip, not a buying opportunity. If however, there were a sustained rise in volatility and prolonged market weakness, perhaps triggered by rising geopolitical risk (or rising domestic risk for that matter), I would look for a good re-entry point and an opportunity to reallocate to risk assets.

 

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