Exploring What Geopolitical Risk Means for Portfolios

09 December 2022
8 min read

Many asset owners remain uneasy about the potential impact of geopolitical risk on their portfolios. Based on conversations we’ve had with clients, we think the concern will continue into 2023. At its heart, the issue isn’t about only the directional impact on assets; it’s also about how to manage this risk, given that it impacts portfolios in different ways from the business cycle or central-bank policy.

In our view, the macro framework many investors rely on includes recency biases, including an assumption that the regime of the past 30 years—which included falling inflation and yields—can last. This can lead to an overreliance on duration in portfolio allocations. Perhaps less obvious a recency bias is anchored on the past 70 years of the US-led world order, though it’s a bias that’s hard to unstitch from investment methodology.

We’ve been asked what level of risk premium would be enough compensation for the potential of open conflict in Asia, and to be honest there’s no realistic near-term prospect of a premium high enough to satisfy investors. The market generally does a poor job of pricing geopolitical risk, with a tendency for sudden increases in risk premiums when events deteriorate.

Treasury Bonds: Downside Mitigation vs. Strategic Considerations

Duration’s reputation as a source of portfolio protection took a serious hit in 2022, leaving its strategic role subject to debate. Our view is that the stock/bond correlation will range from zero to modestly positive for some time, given high and volatile inflation. And inflation is likely to be higher over the long run, implying that global high-grade bonds will earn only a marginal real return.

For long-horizon investors, the essential question is: Which return streams offer attractive real income and diversify equity risk? We think the likely mix would include Treasury Inflation Protected Securities (TIPS), credit, private assets and factor strategies.

We also reiterate our view that there’s no such thing as a risk-free asset, especially given the changed geopolitical climate following the demise of the US-led world order and the attempt by some parts of the world to de-dollarize. This is another consideration for investors assessing the role of sovereign bonds in asset allocations.

However, the role of Treasuries in a given portfolio depends on the nature of investors’ liabilities (whether they’re nominal or real) as well as their investment time horizon. The story of Treasury bonds as drawdown protection is quite different over shorter time horizons compared with longer horizons, where their role is moot.

While Treasuries didn’t perform a defensive function in 2022, the environment was heavily influenced by the upward path of domestic interest rates and the high degree of central-bank hawkishness. We believe that an acute geopolitical shock is different. On one hand, it might imply a deteriorating fiscal position, but on the other hand it’s the kind of exogenous event that could very well cause a pivot in central-bank policy.

What’s more, global investors would be highly likely to flock to US Treasury bonds (2022 taught us that they wont be flocking to crypto assets!). For investors not blessed with long time horizons and in need of protection against short-term drawdowns, Treasury assets are likely part of the allocation.

Assessing Drawdown Protection and Income for Returns Streams

One way to evaluate the trade-off between income and drawdown protection for different strategies or return streams is to compare net-of-fee returns, which can be thought of as the normal ongoing return for an asset or strategy, to the average return in past equity drawdowns (Display). Even if we apply a haircut to 10-year Treasury expected returns to reflect current yields (which are higher over the past 12 months but lower than past decades), they still form a key part of the defensive strategy in this context.

The Trade-off Between Income and Drawdown Protection
A comparison of drawdown protection and income for various returns streams.

Past performance does not guarantee future results.
Monthly data from January 1990 to December 2021. Median return during drawdowns is calculated as median return over the 10 largest US equity drawdowns since January 2000. Private equity, private debt, farmland and timberland series are quarterly, with drawdown periods matched to the nearest quarter. Assumes 10 basis-point fee for US 10-year bonds, gold, REITS, TIPS and high-yield bonds; 20 basis points for long only (L/O) factors; 50 basis points for long/short (L/S) factors; and 150 basis points for timberland, farmland and private debt. Option strategies are shown for one-year 15-delta puts, market-cap weighted and delta-hedged daily. 
Source: AQR Capital Management, Bloomberg, Cambridge Associates, Cliffwater, FactSet, Ken French database, NCREIF, Thomson Reuters Datastream and AllianceBernstein (AB)

More broadly, this comparison of income and drawdown protection also touches on major topical themes for asset allocators, including the role of private assets and factors in portfolios.

The Equity Risk Premium: The Geopolitical Transmission Mechanism

The main transmission channel from geopolitical risk to equities is through the equity risk premium (Display), in this case as defined by the 10-year inflation-adjusted equity earnings yield minus the 10-year inflation-adjusted bond yield.

To proxy geopolitical risk, we can use the Geopolitical Risk Index developed by Dario Caldara and Matteo Iacoviello of the Federal Reserve Board. It counts the share of media articles discussing adverse geopolitical events and associated threats by searching historical archives of the Chicago Tribune, New York Times and Washington Post. It can be a helpful in analyzing how markets are pricing geopolitical risk.1

How Geopolitical Risk Transmits to Equity Markets
US Equity Risk Premium and Geopolitical Risk Index
The relationship between a geopolitical index and the equity risk premium over time.

Past performance does not guarantee future results.
Equity risk premium is defined as 10-year inflation-adjusted earnings yield minus 10-year inflation-adjusted bond yield.
Through October 15, 2022
Source: Robert Shiller's database, Thomson Reuters Datastream, www.matteoiacoviello.com and AB

While the two time series we’re comparing have different properties, increases in general geopolitical risk have often sparked upward shifts in the risk premium. For instance, the spike in the Geopolitical Risk Index in the 1950s as a result of the outbreak of the Korean War coincided with a sharp rise in the US equity risk premium. Similarly, both indices saw sharp spikes around other key geopolitical shocks, such as the Yom Kippur War in 1973 and the Iraq War in 2003.

Tactical and Strategic Impacts from Supply-Chain Disruption

Geopolitical risk also poses a risk to supply chains. Further escalation of the conflict in Ukraine would arguably have less impact on the energy supply now than the aggregate impact to date, but it could make more countries less willing to take Russian energy assets. An escalation over Taiwan would be a supply shock of a different order: the supply of semiconductors would be a case in point, but the dislocation would likely be much broader.

Distinct from the tactical supply-chain effects of a specific spike in geopolitical risk, the strategic impact from a future of generally higher geopolitical tension will likely be far-reaching. As firms adapt their supply chains over the coming decade, it will strain margins. Governments will likely ramp up their involvement in supply-chain choices. The net impact, from a strategic asset allocation perspective, would likely be lower growth and higher risk premia.

The Pattern of Factor Returns in Geopolitical Shocks

Historically, equity factors have followed a similar performance pattern during episodes when geopolitical risk flares up (Display), which provides insight into the possible tactical investment response to this type of risk.

Factor Performance During Periods of Heightened Geopolitical Risk
Median Long/Short Factor Returns in Elevated Periods of Geopolitical Risk Index
Equity factor annualized returns over various time horizons.

Past performance does not guarantee future results.
Median return of select equity factors starting from the adjacent trough in the Geopolitical Risk Index to major political events since January 1950, including the Korean War, Cuban Missile Crisis, Six Day War, Yom Kippur War, Gulf War, 9/11 and Iraq War.
As of November 29, 2022
Source: Ken French database, Thomson Reuters Datastream, www.matteoiacoviello.com and AB

It’s perhaps not surprising that a simple value factor underperforms initially, given its generally procyclical nature. But once the peak period of geopolitical risk passes, value has gone on to outperform. Quality tends to be the inverse of value. Interestingly, income factors, such as dividend yield—especially measures based on free cash flow—tend to perform well throughout, given cash flows’ role between value and quality in the spectrum of factor definitions.

We would expect a serious escalation in geopolitical tension to increase the correlation between assets across regions, so a tactical jump in tensions could be expected to serve as a drag on the returns of risk assets generally.

However, if geopolitical risk rises over a strategic, semipermanent time frame, it could favor North American assets on a relative basis. As we pointed out in our recent deglobalization research, that continent is somewhat less affected by risks to necessities such as energy and food supplies. Access to semiconductors is another matter, of course—any disruption to that supply would have global repercussions and can’t be ignored.

A Responsibility Consideration with Geopolitics

While our focus here is on investors’ unease about the acceptable pool of investment assets when geopolitical tensions rise, there’s also a link to environmental, social and governance considerations. One might work hard to produce return and risk forecasts, only to have their accuracy fade into relative insignificance if demand suddenly emerges to divest from certain investments or if investors are unable to sell them.

After Russia’s invasion of Ukraine, many clients were asking whether China would be the next geopolitical hot spot. The questions reflected two developments: the weaponization of dollar access and reciprocal sanctions as well as a desire among some asset owners to invest responsibly (with diverse interpretations of what that might mean). In the context of geopolitical investment risks, this issue prompts two issues: (1) the risk of capital controls and (2) client-led demands to divest.

It’s very hard to make forward-looking statements about this topic; any change in the status quo depends very much on the idiosyncrasies of specific events as they unfold on the global stage. However, if one focuses on the largest asset exposures in portfolios, then the key risk would be to the status of Chinese assets in the view of outside investors.

The Big Picture

We clearly live—and invest—in an era of higher geopolitical risk, which brings both tactical and strategic implications for asset allocation. The implications differ based on time horizons. For investors with shorter horizons and a high aversion to drawdowns seeking to incorporate the risk of sharply elevated geopolitical risk into their approach, high-grade bonds will likely play an important role in their allocation—even though they struggled to diversify in 2022.

Preparing for heightened geopolitical risk from a strategic point of view leads us back to many of the core questions investors face today: What role do government bonds play in a portfolio? What’s the best way to allocate to public and private assets? How will the increase in risk premia and slowing growth crimp risk-asset returns? To what extent will the US be able to pull away from the rest of the world? These questions will be subject to much analysis and discussion in the year ahead.
1 For more information, please see: Caldara, Dario and Matteo Iacoviello (2022), “Measuring Geopolitical Risk,” American Economic Review, April, 112(4), pp.1194–1225.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.

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