Investing in a World of Heightened Geopolitical Uncertainty
By Talha Khan
Capital Group Political Economy Analyst
Military conflicts in Syria, Ukraine and elsewhere have raised humanitarian concern for civilians caught in harm’s way and sparked fear that geopolitical turmoil could further weigh on global stock markets. Even though armed conflicts are common, the sheer number and intensity of the current showdowns are unsettling.
My colleagues and I are paying close attention to daily developments in trouble spots around the world. We have met with policymakers and private think tanks to assess the potential economic and market effects.
Of course, it’s never possible to predict how an individual crisis will play out or how financial markets will react. Historically, however, geopolitical flare-ups have generally had minimal effects on equity prices in the short term and virtually no impact when viewed from a longer-term perspective.
To determine the effect of armed conflicts on the equity markets, I examined how the S&P 500 fared during 107 wars and 248 militarized disputes dating back to 1960. (A militarized dispute is classified as a conflict that is shorter and more contained than an outright war.) On average, I found that the S&P 500 dips modestly at the onset of hostilities but typically recovers quickly and is notably higher by the time fighting stops. Investors view most military conflicts as geographically isolated with limited risk of affecting the world economy. There is an exception when clashes threaten to disrupt global energy supplies or push up oil prices. In those cases, the up-front drop in stock prices is more pronounced. Even then, however, the S&P 500 often shows notable gains by the conclusion of tensions.
In regard to recent conflicts, it’s too early to draw conclusions. That said, the S&P 500 has held up relatively well this year as investors have focused more on improving economic conditions.
The world may be entering a period of escalating geopolitical uncertainty.
Despite the U.S. equity market’s historically muted reaction to armed crises, it’s important to note that significant geopolitical changes are taking place around the world. Such shifts indicate that we are entering a period of heightened risk that could increase volatility in the financial markets.
Indeed, most of the past three decades have been marked by relative geopolitical stability. Though that period included the first Gulf War and the 9/11 terrorist attacks, it also saw the fall of the Berlin Wall, the end of the Cold War and the demise of the Soviet Union. Economically, it was a time of unprecedented global financial integration marked by deregulation, falling trade barriers and restrained inflation. Capitalism became the dominant ideology in key areas of the globe.
Such stability was underpinned by perceived American dominance, both economic and military. In political parlance, it was a unipolar world. Today, by contrast, the U.S. can no longer dictate global affairs as it once did because it has been less willing and able to serve as the global police force. This has contributed to a structural shift in the balance of power. We’re now in a multipolar world in which a number of countries and non-state entities are pursuing individual nationalistic goals without constraints imposed by an overarching superpower. Geopolitical conditions may change depending on U.S. and Chinese reactions, but the near-term effect is likely to be increased volatility in the equity markets as crises flare.
Given these risks, we are closely monitoring developments as they occur. We track everything that can influence stock prices, and major geopolitical events certainly can affect a company’s revenue or earnings. Among other things, we assess the added costs faced by companies operating in troubled regions. We also analyze whether the potential investment returns in our portfolios justify the heightened risks. Geopolitics is only one factor that we consider. We remain focused on in-depth fundamental analysis to assess the complete long-term outlook for the companies in which we invest.
The Ukraine crisis has stirred fears about the potential financial impacts on Europe.
The conflict in Ukraine has taken its toll on the Russian economy, in part because of Western-imposed sanctions. Stocks have been weak, the ruble has fallen sharply, and growth has slowed. The effects have been muted to a degree by the reluctance of some European countries to enact stricter sanctions. France, for example, doesn’t want to cancel contracts to supply military equipment to the Kremlin. On a broader level, there’s fear that the conflict will hurt Europe’s already weakened economy through reduced exports to Russia and decreased investor confidence. However, a worst-case scenario — a cutoff in Russian supplies of natural gas to Europe — seems unlikely. The most probable outcome is that the Ukraine dispute will be drawn-out and therefore will need to be continually monitored over time.
In the Middle East, investors have become accustomed to the prevailing state of imbalance. Like the rest of the world, they have been shocked by the sudden emergence and brutal tactics of the extremist group known as the Islamic State. Beyond that, there is dismay at the latest clash between Israel and Hamas. But from a longer-term perspective, investors do not perceive sustainable threats to energy supplies or prices.
It’s essential to keep one’s focus on the long term.
Without question, my analysis on this subject has natural limitations and is intended only as a very broad measure of the past. There is high variance in how markets react to different events. That said, militarized disputes have only had a minimal effect, especially when the U.S. isn’t involved in a major way. Thus, although it’s important to understand geopolitical trends, they are often temporary in nature and usually do not have a lasting effect, especially for long-term investors.
Talha Khan is part of the Capital Group Strategy Research Team, focusing on how the global political environment impacts economies. He is based in our London office and has been with Capital Group since 2009.