How global events could be impacting your investment portfolio
Some significant and, at times, unexpected global events have heightened geopolitical tensions over the past year. The fallout over Brexit continues, there’s been an increase in terror-related incidents, Donald Trump took charge of the White House, North Korea accelerated its nuclear weapons regime, and there’s potential for a government shutdown in the US.
Under normal circumstances, we would expect markets to have a negative response to such events. However, we’re noticing an increasing trend of muted responses to these types of geopolitical risks with incredibly low levels of volatility. And this could be impacting how you invest. Here are two key geopolitical and economic issues with the potential to escalate that demonstrate why investors should keep a global view when considering portfolio diversification.
North Korean missile tests
The risks surrounding North Korea’s nuclear weapons regime heightened in August this year when the country successfully tested a hydrogen bomb. This action suggests North Korea’s nuclear weapons are more developed and far reaching than previously anticipated. The test was North Korea’s most powerful to date and is estimated to be six times more powerful than its previous largest successful test and eight times more than the bombs dropped on Hiroshima and Nagasaki during World War II.
The frequency of North Korean missile tests has increased significantly since Kim Jong-un came into power in 2011, including 21 missile launches during 14 tests since US President Trump’s inauguration. This frequency emphasises North Korea’s focus on perfecting its armoury (useful as a bargaining tool), in turn highlighting the risk that tensions in the area may escalate in the coming months or years.
US debt ceiling
The US government reached its debt ceiling earlier this year and was only officially funded until 30 September until President Trump negotiated a deal to kick the can down the road until 8 December 2017, partly in light of the need for funds to remediate Hurricane Harvey. Should the government fail to reach an agreement with Congress by that time, it may be forced to shut down, which is likely to have ramifications across not only US equity markets, but global equity, bond and currency markets.
Debt ceiling crises occurred twice during Barack Obama’s presidency, the first of which, in 2011, was incredibly severe. The peak-to-trough fall of the S&P 500 throughout this crisis was a loss of 18 per cent and saw the downgrading of the long-term credit rating of the US government for the first time in history. The second in 2013 actually saw the government shutdown for 20 days. Strangely enough, over this period, equity markets actually gained 3.1 per cent, further highlighting that market responses to geopolitical tensions are not always predictable. The coming months promise political volatility as the negotiation deadline looms. However, it is unknown if this will equate to equity market volatility.
Under normal circumstances, pairing a potential US government shutdown with ongoing tensions around North Korea’s nuclear weapons would see markets react negatively and see investors seek out safe haven assets.
As we’re in a prolonged low volatility period, markets may not respond as we expect
As geopolitical risks have heightened, market responses appear to have become increasingly more subdued. While historically it has been extremely difficult for markets to price in geopolitical risk, the low level of volatility in recent times has been confounding. A trend appears to be emerging whereby major geopolitical events are seen as a headwind to market performance and not a catalyst for a major sell-off. This trend may be an outcome of current market conditions.
Low interest rates and historically high equity valuations have resulted in investors consistently searching for value. Therefore, apparent market corrections, as a result of geopolitical factors, are seemingly creating buying opportunities for value hunters (noting the significant availability of cheap money to invest) and not allowing markets to accurately price in geopolitical risks.
It may mean that valuations may not be truthfully reflecting the risks facing investors, and we remain concerned that current investor complacency may be punished if and when this trend reverts.
Based on this view, portfolios should be diversified across a range of underlying investments
We believe it’s important to include an allocation to defensive assets such as infrastructure and property, and maintain a healthy level of US dollar exposure given its status as a safe haven currency. We continue to recommend portfolios have a healthy weighting towards cash, as it provides liquidity should geopolitical factors come to a head and investors face market turmoil.
This insight may contain general financial advice and was prepared without taking into account your objectives, financial situation or needs. Before acting on any advice, you should consider whether the advice is appropriate to you. Seeking professional personal advice is always highly recommended. Any forward looking statements are based on current expectations at the time of writing. No assurance can be given that such expectations will prove to be correct.