Investing in a Disorderly World

WHILE GEOPOLITICAL OR “HEADLINE” EVENTS can trigger turmoil in financial markets, their effect is usually short-lived. What’s more, there are steps investors can take to prepare for them. In the discussion below, Joseph Quinlan, head of Market and Thematic Strategy at Bank of America Global Wealth & Investment Management, provides his perspective on the impact of such events on global financial markets and discusses strategies you might consider to manage the risks.

Q: How do you define geopolitical risk as it applies to the investment realm?

A: Geopolitical risk, to put it simply, is the risk that a geopolitical event — anything from a major terrorist attack to an unexpected election result in Europe — triggers a fundamental shift in asset prices. The vote in Britain to leave the European Union (also known as Brexit) and Russia’s annexation of Crimea are two fairly recent examples of a geopolitical event. Some events are absorbed pretty easily by the markets; others can trigger a market rout, at least in the short term.

The impact on the price of securities like stocks, bonds and commodities, varies with the event. The fallout is most severe if the event is perceived as altering the existing political and economic order, which, in turn, could impact economic growth, corporate earnings, asset prices and investor behavior. However, in most cases, the global financial markets bounce back fairly quickly following even a large geopolitical event. They react strongly at first and then quickly revert to business as usual. A major geopolitical event can become a nonevent very quickly.

Q: Why does the sentiment change so quickly? Do investors have a short attention span, or is it that they are more optimistic than we might assume?

A: I think optimism actually plays a part in it. Since World War II, we’ve been blessed with relative peace and prosperity. We’ve had regional conflicts that have been costly in terms of blood and treasure — wars in the Middle East being a prime example — but we haven’t seen any global conflagrations that have set humanity back for decades. Europe has been peaceful for 75 years; China’s rise has been peaceful; the Soviet Union collapsed under its own weight, not from war. This postwar stability has supported strong global growth. Per capita income has grown significantly not only in the developed countries, but also in the emerging markets.

So I think the behavior of the financial markets after a crisis reflects an innate confidence that things will work out because they generally have for several generations now. This is due in large part to the institutions established after World War II — the United Nations, NATO and the International Monetary Fund — that have headed off crises or helped restore equilibrium after one. Pessimists might argue that this confidence in the future is more about complacency than optimism, but whatever the reason, the markets have tended to bounce back pretty quickly from even major geopolitical upheavals.

Q: Have globalization and the greater connectivity among the world’s economies magnified the impact of geopolitical events or helped to mitigate the damage from them?

A: I think globalization widens the area of impact from a geopolitical disturbance, but it can also help prevent a crisis from intensifying. To the latter point, commerce among nations promotes peace because it gives them a vested interest in maintaining stability. A journalist once said that whenever two countries have McDonald’s, they don’t go to war. That’s taking the point way too far, but it is true that global trade creates linkages among nations that incentivize them to maintain the status quo. That said, globalization sometimes does exacerbate crises, the 2008 financial crisis being a good example. The connections among global financial institutions allowed problems at a few U.S. institutions to spread around the world. Generally though, globalization is a close associate of peace, which has been good for investors.

Q: Are there long-term trends that you believe could be problematic for investors?

A: Rising populism is somewhat worrying in that it could lead to a loss of support for the norms and institutions that support the liberal political and economic order. We’ve already seen a decline in support for open borders in Europe and for multilateral trade agreements like NAFTA. If the trend continues, there is greater potential for truly disruptive geopolitical developments like the disintegration of the European Union, although that doesn’t seem as likely as it did a few years ago even with the Brexit vote.

The greatest risk is advances by fringe political parties that undercut traditional democratic values like religious tolerance and belief in the rule of law. The good news is that historically, democratic societies have responded to social discontent before it posed a dire threat to their way of life. Positive change can come even to autocratic societies; witness women now being allowed to drive in Saudi Arabia. So there’s reason for concern, but also reason for hope.

Q: What do you tell clients who ask for guidance on mitigating the impact of geopolitical events on their investment portfolios?

A: The first thing we tell them is not to overreact to any given event or crisis because, as I mentioned, the markets often have bounced back from even major geopolitical developments, whether it’s 9-11 or Brexit. So you don’t want to make big changes to your investment strategy because of an event that might only have a short-term impact. That said, geopolitical events can be disruptive, so investors need to account for geopolitical risk just as they account for equity risk, credit risk, and currency risk. It needs to be part of their risk management effort. And, of course, being well diversified across all asset classes and having a long-term investment strategy that reflects your financial goals and risk tolerance can help you weather unexpected market events and the disruption they can cause.