Markets & Economy

Revisiting Geo-Political Risk for Investors

Revisiting Geo-Political Risk for Investors
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The end of the Cold War ushered in a new era of global political stability that lasted for a quarter of a century. Signs suggest this hiatus has now run its course but are investors prepared?

The end of the Cold War ushered in a new era of global political stability that lasted for a quarter of a century. As the U.S. became the world’s sole remaining superpower, its global values of liberal democracy and free market capitalism were widely accepted. However, the world order is fluid, and American ‘exceptionalism’ is being challenged. Global political conflict is intensifying and often conducted through unconventional, indirect means. Geopolitics will have a much more powerful influence on global equity markets going forward and should not be underestimated as a result.

In his 1989 essay “The End of History?” political philosopher Francis Fukuyama contended that, with the end of the Cold War, the world was entering a final form of human government with liberal democracy and free market capitalism the accepted consensus.

For the past 25 years, his theory has largely been correct. However, countries are not static and neither are their international political ambitions. Once-poor countries like China have become considerably wealthier and now demand a political voice on the world stage to match their economic status. Russia, the core of the former Soviet Union, has recovered from its lost decade of the 1990s and once again pursues imperial ambitions.

A multitude of other countries, including Brazil, South Africa, Turkey, Egypt, Saudi Arabia, Iran and Indonesia, enjoy more regional political autonomy than they have in generations.

The rise in international political ambition of these states is coinciding with the U.S. redefining what its international role should be under the Trump administration and the rise of domestic populism. A more isolationist U.S. focused on cutting bilateral deals and putting “America First”, rather than underpinning a multilateral system of liberal values will inevitably lead to greater political instability on the international stage. We contend Fukuyama’s “End of History” has ended.

GEOPOLITICS MATTERS BECAUSE THEY SHAPE WORLD ORDER

Financial markets have become accustomed to a world order dominated by the U.S. and underpinned by its values of free trade and liberal democracy. As globalization flourished so did multinational enterprise along with the avenues it enjoyed for making profits. At the same time, the equity market embedded a low global political risk premium in its cost of capital. Now, as the dominance of the U.S. slowly erodes and other nations expand their own regional (or even global) spheres of influence, these liberal democratic values favorable for multinational commerce are no longer guaranteed.

Contemporary geopolitical events receive substantial media coverage, including North Korea’s nuclear missile program, Russia’s annexation of Crimea, Syria’s civil war and China’s increasing territorial claims over the South China Sea. With the exception of minor short-term blips, none of these events have dented market confidence or led to meaningful stock market corrections. Critics have therefore questioned whether geopolitics really matters for financial markets. We make three observations in response.

1. Second-order effects

We believe investors will increasingly focus on the second-order effects of geopolitical events, rather than the primary events themselves. To illustrate, market participants already expect North Korea to develop nuclear weapons, hence further progress on this front is unlikely to surprise. However, the second-order effect might involve the Trump administration punishing China for continuing to support Pyongyang, with China retaliating. The resulting tit-for-tat would have much more profound implications for markets.

2. Slow but profound shifts

We believe the tectonic shifts occurring in the international political environment are slow moving but extremely profound. Liberal political assumptions of institutions such as free trade, freedom of navigation and rule of law are discounted in equity cost of capital today but, as our analysis and experience of emerging markets shows, such assumptions can change dramatically over time. We expect a potentially higher global political equity risk premium going forward.

3. Distorted capital flows

We do not believe markets are fairly pricing the level of current and potential global geopolitical risk due to distortions such as central bank liquidity. Another explanation for the recent complacency toward geopolitical risk is the rise of exchange-traded funds (ETFs), which has distorted capital flows into equities.

However, recent price action of political risk-off assets including gold, the Swiss franc, the Japanese yen and the “Defense” Index (Dow Jones U.S. Select Aerospace & Defense Index) is becoming more acute in response to the most recent geopolitical events. In short, geopolitical risk is starting to get noticed, and we believe active equity asset managers are well positioned to capture the benefits and avoid the pitfalls.

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Risks

All investments involve risk including loss of principal. Certain investments involve greater or unique risks that should be considered along with the objectives, fees, and expenses before investing. Equities are subject to market, market sector, market liquidity, issuer, and investment style risks to varying degrees.

Views expressed are those of the advisor stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Please consult a legal, tax or investment advisor in order to determine whether an investment product or service is appropriate for a particular situation. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. The Dreyfus Corporation and MBSC Securities Corporation are subsidiaries of BNY Mellon. © 2018 MBSC Securities Corporation, distributor, 225 Liberty Street, 19th Fl., New York, NY 10281.

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