Risky assets investing amid political tensions can be 'good strategy'

Schroders has been doing research looking at the correlation between geopolitical risk and market behaviour.

In its analysis, the firm identified five different periods of geopolitical uncertainty since the 1980s. 

It then built two portfolios; one safe and the other risky and compared their returns over the periods.

The safe portfolio included gold, Japanese Yen, and Swiss Franc, while the risky portfolio comprised SNP 500, MSCI World and MSCI Emerging Market index.

When the returns in the portfolio were compared with each other, Schroders found in the majority of cases, the safe portfolio outperformed the risky portfolio.

In addition, when the firm looked at risk adjusted returns, the Sharpe ratios of the safe portfolio were higher than the Sharpe ratios of the risky portfolio.

Ms Lauro says: “In our analysis, we realised the equity markets start to rebound after a few months from a geo-political shock, so we extended the time window of our analysis to six months after the geopolitical tension dissipated. 

“In this case the risky portfolio outperformed the safe portfolio over the periods we considered. Our analysis suggests if global equity investors are willing to withstand a considerable amount of volatility then remaining invested in risky assets is a good strategy.”

Paying close attention to geopolitical risk, which can have a significant impact on financial markets, will also help investors to be aware of any potential risks to their portfolio.

She says: “We do find that investors should pay a lot of attention to geopolitical tensions when making tactical allocation decisions.”

Ms Lauro points to the killing, earlier this month, of Iranian General Qasem Soleimani as an example of an event that boosted the value of the safe haven assets, such as gold and Swiss Franc.

An impending major geopolitical event, Ms Lauro says investors should be paying attention to, is the US elections.

She adds: “A change of presidency to a democratic administration would be a potential headwind for the SNP 500.

“We have a ‘US swings left’ scenario, where we think policies such as higher regulation or increase of the minimum wage will be implemented and these policies will have a significant impact on activity.”

Higher regulation means lower business sentiment and could therefore be a drag on business investment, while an increase of the minimum wage could squeeze corporate profits, as corporate profits are a key driver of equity returns.

A change in presidency could also mean a reversal of Trump’s tax reform.

Ms Lauro says: “In 2018, pre tax profits barely grew, rising less than 1 per cent year on year, while SNP 500 recorded a stellar performance in that year with earnings per share rising more than 20 per cent.

“This divergence is due to the reduction in the federal tax grade under the Trump administration. Any reversal of that tax reform could hit the SNP 500, so investors do need  to pay attention to what’s happening in the political landscape in the US.”

To ensure optimal allocation to ensure funds are not over reliant on a single political outcome, within its multi-asset framework, Schroders uses scenario analysis to deal with different political outcomes. 

Mr Lauro adds: “We build a baseline scenario which incorporates what we think is most likely to happen then we have alternative scenarios. 

“For each of them we try to work out their implication for financial markets. We then apply a probability to each of the scenarios and we build the portfolio accordingly. Within the equity division instead, the strong bottom up approach ensures the  portfolio is never too exposed to geopolitical risk.”