Today, global economies are more connected than they have ever been. Political events or natural disasters in far flung corners of the globe can send shockwaves through the financial markets here in the United States. Given this reality, geopolitical risk may be a concern for investors. Political instability, international conflicts, or even major policy shifts are no longer distant headlines; they may influence the performance of your portfolio. Let’s take a look at some strategies for navigating this potential uncertainty.
Understanding geopolitical risks
Geopolitical risks are the financial and economic effects from international political events or relations between countries. Examples of such risks include war, trade disputes, economic sanctions, civil unrest, major elections, and policy shifts. For investors and companies, these events are significant because they can disrupt markets, impact economies, and create widespread uncertainty.
In recent years, the frequency and complexity of these risks have intensified. A globalized world means that supply chains, capital flows, and market sentiment are inextricably connected. A regional conflict can quickly escalate into a global economic problem, making it crucial for investors to understand international events and how they can affect investments.
Take the war in Ukraine, for example. Months after the conflict began, energy prices and agricultural supply chains throughout Europe were rattled.
Then there’s issues over climate change.
Disputes over water rights, competition for resources in the melting Arctic, and mass migration driven by climate events are all creating new points of friction between nations. These risks directly impact many industries, from agriculture to insurance to energy and infrastructure.
This is only the tip of the iceberg when it comes to the myriad ways these conflicts can reverberate through the global economy, and shake the sentiment of the market.
Potential impact of geopolitical risks
Understanding geopolitical risk is only half the battle. Investors must also realize how these events translate into tangible market movements.
Volatility in financial markets
Geopolitical shocks are one of the primary drivers of market volatility. Sudden escalations or unexpected political outcomes have, historically, often triggered sharp selloffs in equity markets as investors fled to what they considered safety. This potential flight could increase demand for other forms of assets like gold, the U.S. dollar, and government bonds.1 In turn, currencies may also fluctuate significantly as capital moves across borders in response to perceived risk.
Sector-specific impacts
Historically different sectors have reacted to geopolitical events in distinct ways.
- Energy: Conflicts in oil-producing regions or sanctions on major exporters in the past have caused crude oil and natural gas prices to rise, which benefited energy companies but increased costs for consumers and businesses alike.
- Defense: Increased global tensions and conflicts have often triggered higher government spending on military hardware and cybersecurity, possibly boosting the performance of defense and aerospace stocks.
Supply chain disruptions
Modern supply chains are long, complex, and extremely vulnerable. Geopolitical events can sever critical links, causing production delays and shortages. For example, in 2022, Russia’s invasion of Ukraine caused significant supply chain disruptions in energy and agriculture.2 More recently, Houthi attacks on Red Sea shipping disrupted global supply chains by forcing ships to reroute around Cape Horn, adding considerable expense and time to the movement of goods.3 Such disruptions can not only hurt corporate profits but also may fuel inflation, creating a challenging environment for central banks and complicating economic policy.
Emerging markets vulnerability
Emerging markets often can have the greatest exposure to geopolitical shocks. These economies can experience rapid capital flight, should international investors pull money out in favor of assets considered safer. This can lead to currency depreciation, making it harder for these countries to pay foreign debts and finance imports. Their reliance on global trade also can make them particularly vulnerable to protectionism and supply chain breakdowns.
Strategies for navigating geopolitical risks
While these risks are impossible to eliminate, investors can adopt strategies to help mitigate their impact.
Diversification
We believe the most fundamental principle of risk management is diversification. Spreading investments across different asset classes (stocks, bonds, commodities), geographic regions, and industry sectors can help shield your portfolio from a shock that disproportionately affects one geographic region or sector. A well-diversified portfolio should be less likely to suffer catastrophic losses from a single political event.
Alternative investments
During periods of past upheaval, certain assets have tended to hold or increase their value. Gold has historically been a reliable store of value during past geopolitical crises.4 U.S. Treasury bonds are also considered by many a less volatile asset due to the historical stability of the U.S. government. Including a strategic allocation to these assets could help preserve capital during market downturns.
Focus on resilience
Investing in companies with strong fundamentals and resilient business models is also a key strategy. Look for businesses with low debt, strong cash flow, and diversified supply chains.
Stay informed
Understanding the context behind the headlines should allow you to make more rational, less emotional investment decisions. Knowledge can be the best defense against emotional reactions to market volatility.
The takeaway
Geopolitical risks are an unavoidable part of investing. While such risks are unpredictable and complex, they are not unmanageable. By understanding the key risks on the horizon, recognizing their potential market impacts, and implementing sound strategies like diversification and a focus on quality, investors can stay focused on what matters—and for many, that’s the long-term.
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