The world is facing a period of heightened geopolitical risk. Traditionally, we think of this as the risk of sudden, unpredictable events: coups, riots or revolutions—the political equivalents of earthquakes. But with the stresses facing the global economy today, we are seeing a level of government intervention in economies and markets that is unprecedented in recent times. For investors, this is creating a broader set of political risks than they typically face, including uncertainty around the direction of government policy, the possibility of policies adverse to their interests and the risk of policy mistakes.
As a result, markets are being driven less by fundamentals than by the interplay between short-term economic news and governments’ responses. This has created a difficult environment for fundamental investors in global markets, many of whom have generated disappointing returns relative to their benchmarks over the last few years. The level of uncertainty is such that even global macro hedge funds, whose policy/geopolitical risk management credentials should lead them to profit from this sort of environment, have been struggling.
A framework for distinguishing risks
There are no easy rules of thumb for how to manage political/geopolitical risk. However, to paraphrase the famous assertion by Donald Rumsfeld, former U.S. Secretary of Defense (made at a 2002 press briefing on the situation in Iraq), we can distinguish risk in three possible ways: known knowns, known unknowns and unknown unknowns.
Unknown unknowns
In Rumsfeld’s words, unknown unknowns are “things we do not know we don’t know.” These events (e.g., terrorist attacks or the recent revolutions in Tunisia and Egypt) cannot reasonably be predicted and can be “managed” by an investor ahead of time only by ensuring that the portfolio is adequately diversified.
Such events look likely to become more significant for investors. Repressive or corrupt regimes such as those in Iran, Pakistan, Syria and North Korea are coming under unprecedented internal pressure to reform, and this has the potential to create local flashpoints that might have regional or global consequences—particularly to the extent that they impact the global oil supply.
At the same time, the possible waning of U.S. military power and influence means that the consequences of such events might be more chaotic. Mike Mullen, chair of the Joint Chiefs of Staff, recently warned that the impact of U.S. debt levels on military spending posed the greatest threat to the nation’s (and, therefore, global) security, as the military would not be able to maintain its global presence.
At the same time, it seems that the current administration is choosing to play a less proactive role in international disputes. Should the U.S. falter in its leadership role, the world would become more dangerous. Without the security provided by a single pre-eminent power, the world is likely to suffer a protracted, risky period of inconclusive attempts at regional alignments with no evident stable outcome.
Managing the unknown unknowns
Recently, markets seem to have overreacted to sudden geopolitical events of this type, perhaps driven by aggressive hedge fund selling. As a result, an investor who decides to reduce risk after an event by cutting exposure to a particular country or region is locking in a loss that might resolve itself. In the context of an appropriately diversified portfolio, a better strategy—and one that fundamental investors seem increasingly to adhere to—is to ride out the episode, at least until the longer-term consequences of the event become clearer.
Known unknowns
“We know there are some things we don’t know,” said Rumsfeld. These events largely comprise policy decisions by governments and monetary authorities and factors (such as elections or orderly leadership changes) that can affect them. We know these things have to occur, but we are uncertain of their outcome.
It is this risk category that is currently proving most difficult for investors to deal with. The acute economic problems of the last few years have resulted in unusually activist governments and many unorthodox policy prescriptions. The uncertainty that results when political decisions become a major short-term driver of prices caused volatility to soar in early 2008 from the almost unprece-dented lows it had enjoyed from 2004 to 2006. It has remained generally high since.
Until recently, investors have seen this type of “policy” risk as primarily an emerging market issue. However, since the numerous emerging markets crises of the 1990s, geopolitical risks in these emerging countries have been steadily declining. Globalization provided a platform for stable economic growth. The spread of liberal democracy generally (though not always) reduced the potential for social unrest. And macroeconomic management has improved as a new generation of western-educated leaders applied lessons learned from earlier crises, particularly in the area of managing currency regimes.
Geopolitical risk in the developed markets was seen, until recently, as virtually non-existent. During the 1990s and the early part of the last decade, it was increasingly believed that “geography” didn’t matter as a risk factor in developed markets—political actions were unlikely to be radical enough to make much difference to an investor’s returns. What mattered in these markets was getting the sector, industry and stock decisions right. These beliefs led many professional investment firms to restructure their research around global sectors and industries rather than regions or countries.
However, in an extraordinarily short period of time, markets have come to doubt the motivation and skills of political leadership in many of the world’s leading developed economies. Many of these leaders fumbled in their response to the financial crisis. Horrendous long-term fiscal challenges in many countries are barely being addressed, particularly in the U.S. Europe’s leaders seem unwilling to acknowledge the structural flaws in the common currency, and their misguided prescriptions to date for a “solution” would result in a prolonged economic downturn. As a consequence, many developed markets are now looking riskier from a political perspective than some of the more successful emerging markets.