The past few months have illustrated the range of geopolitical risks with which macro investors must contend, from the expected (like the UK election) to the surprises (like the sudden hostilities between the US and Iran).
Yet, as investors know, risks can be rewarded. In these two cases, for example, we saw UK equities rally after the Conservative victory and the oil price spike briefly after the missile strikes in the Middle East.
The question for us is which geopolitical risks will offer sufficient compensation to merit a place in our portfolios. After all, taking risk does not guarantee a positive return: with December’s general election there was the possibility of a swing towards the Labour party, as happened in 2017, which would not have been so warmly received by the market; and given the leadership in Washington and Tehran, a further escalation in that conflict could not be ruled out.
We therefore undertake rigorous scenario mapping and quantitative analysis to help assess whether the risk premium attached to a macro event is sufficiently high to warrant taking on that risk.
Our mantra is thus ‘prepare, don’t predict’. By analysing a range of possible outcomes in advance, we can attach relative probabilities to them and assess whether the market is over- or under-pricing each eventuality. This in turn means we can position portfolios appropriately before a macro event, including hedging where necessary, so we don’t have to chase market movements after the fact.
To return to our two recent examples, then, a week on from the exchange of fire between the US and Iran we can see that the effect on markets was remarkably short-lived. Equities recovered their losses within 24 hours and oil now trades below its pre-strike price.
This exemplifies not only the benign view the market holds on renewed tensions, but also how the market impact of seemingly seismic shifts in geopolitics can be surprisingly temporary. The economy and monetary policy tend to be the more important drivers for the longer term. It’s also a lesson that if you want to capture a political risk premium, you need to act swiftly.
We were cautious on the obvious trade around this confrontation – going long oil or oil-related assets. Crude prices had already rallied significantly in December, and we believed Saudi Arabia stood ready to increase supply to manage the oil price if needed. It also struck us that the market was placing too much confidence in the reaction function of Presidents Trump and Rouhani; as Emiel has set out, we consider game theory in such situations.
In December, meanwhile, based on the balance of electoral probabilities we did buy UK equities, with the investment case mainly derived from the negative sentiment that prevailed at the time. This aversion to UK stocks may now dissipate given the reduced uncertainty and their cheap valuations, which could bring back foreign investors.
Both of these recent events demonstrate the value of careful scenario analysis of geopolitical risk premia, whether we ultimately act tactically (as in the case of the UK election) or not (as with Iran).
Yet not every political risk premium is rewarded immediately following a binary event like an election, so we are also willing to invest patiently where there is adequate compensation for a more structural political risk.
For example, we hold active positions in both Argentina and Chile – in the country’s bonds and in the peso, respectively – despite their recent troubles. We believe that these assets both offer a political risk premium, which could be unlocked if policymakers do the right thing.
Both countries still face serious issues and are not out of the woods, but with the return of the Fernández family in Argentina we have seen some initial fiscal measures that should bring the country back to a balanced primary budget. Some protesters in Chile have also been returning to work, with the referendum on a new constitution in the country planned for April.
By tactically buying assets exposed to political risks that we believe – through thorough scenario analysis and considering the behavioural biases of the market – are likely to be rewarded, over and over again across different regions, the political risk premium may become a more strategic return source for our portfolios.