Emerging Market Investing: Mitigating Geopolitical Risk

Geopolitical events have always posed a challenge for investors, often leading them to turn defensive, or even ‘flee’ the markets.

However, recent unexpected events such as Brexit and US President Trump’s election have shown that turning defensive has not always helped investment returns, particularly when financial markets seem underwhelmed in their reaction to a major event, or react in a completely unexpected manner.

History, luckily, does offer some evidence. First, most conflicts seem to have only a short-lived impact on financial markets. Look no further than the South Korean equity market index for an example: a long history of North Korean sabre-rattling has only ended up creating buying opportunities.

US President Trump’s initial rhetoric has given way to a more pragmatic outlook, which has arguably helped the continued rebound in emerging market equities

Second, a more permanent reaction seems to take place only when there is a lasting impact on the fundamentals of an asset class. The 1970’s oil embargo is a good example of this, where a geopolitical event (OPEC’s decision to reduce supplies) changed the supply-demand balance of oil, sending prices higher for a sustained period of time.

Right now, we see three geopolitical risks that investors should factor in: Euro area politics, ongoing concerns of restrictive trade policy in the US and the risk of escalation of tensions on the Korean peninsula.

Political Concerns In Europe

Euro-area equities are among our most preferred asset classes globally, together with the euro and emerging market USD-denominated government bonds, based at least partly on what we see to be receding political risk this year.

At the start of this year, financial markets worried that a eurosceptic win in the Dutch, French or German elections this year could trigger renewed uncertainty about the future of the euro area, and lead to severe losses in European equity markets and the single currency.

Tensions surrounding North Korea could pose the biggest challenge to investors

However, the election outcomes have proven otherwise, with pro-EU parties winning the Dutch and French elections. None of the major candidates of the German election later this year is likely to pose a risk to the EU’s future.

Although the surprise outcome in the UK election (leading to a hung parliament) is likely to cloud the outlook for the UK, it appears geopolitical risk from Euro area politics is likely to abate. The Italian election in 2018 could cause more worries, based on current opinion polls, but we believe it is too soon to price in concerns on this front.

International Trade Pressures

Trade tensions are a key risk, more so for emerging markets, including Asia, given the region’s reliance on exports as a key driver of economic growth. US President Trump’s initial rhetoric has given way to a more pragmatic outlook, which has arguably helped the continued rebound in emerging market equities, bonds and currencies.

However, trade tensions are unlikely to go away – the recent US tax on Canadian lumber imports and comments regarding the North American Free Trade Agreement remind us that policy risk for open, export-oriented economies has not permanently disappeared. Our approach has been to favor domestic-oriented markets like Chinese equities within our broader preference for Asia ex-Japan equity markets.

Geopolitics is a factor to consider when making investment choices, but should not be allowed to overwhelm the thought process

Risk On The Korean peninsula

Tensions surrounding North Korea could pose the biggest challenge. A more nationalist US leadership and North Korean efforts to cross the intercontinental ballistic missile threshold suggest a higher-than-usual risk of escalation.

For an investor, this risk is difficult to mitigate because of its potential to cause longer-lasting market damage. A simple approach could be to focus on traditional safe havens like gold or high-quality bonds. However, we believe a broader and more diversified investment allocation that includes a mix of assets may be superior, given how difficult it is to predict the final outcome.

Fundamentals and a sensible approach to asset allocation approach sit at the heart of good investment decision-making. Geopolitics is an additional factor to consider when making investment choices, but should not be allowed to overwhelm the thought process.

We believe our investment case for favoring euro-area equities globally, and China within Asia ex-Japan, is not only valid from a perspective of fundamentals, but also consistent when we add geopolitical risks into the mix.

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