Geopolitics creates unpredictable headwinds – again

Between global headlines about Italy, Iran, Russia and North Korea, geopolitical risk is increasingly on the agenda of investment professionals. This feeds into concerns over the impact of risk on inflation, the economy and financial markets. Derivatives markets offer numerous tools that can provide a hedge or an opportunity to take a position, but charting a course through inherently uncertain waters is no simple matter.

Geopolitics by its very nature is unpredictable. From the recent exit of the US from the Iranian nuclear deal and negotiations with North Korea, to Russia’s actions abroad and the endlessly uncertain political climate in Europe, a revolving cast of actors creates bouts of volatility, which themselves can be unpredictable and of uncertain duration. Not surprisingly, some 70% of investment professionals expect returns to be compromised by geopolitical uncertainties over the next three to five years, according to a 2017 survey by professional association the CFA Institute.

“There is a sense that geopolitical events are becoming more common and more persistent, which perhaps reflects the changing role of the US in the international order, and the fact that Washington is looking more inward than previously,” says Michael Wittner, global head of oil research at Société Générale Corporate & Investment Banking (SG CIB). “This has knock-on effects, for example in the Middle East, where there is a fairly long list of hotspots, and is allowing more countries to flex their muscles.”

Short supply

With US sanctions against Iran set to bite later in 2018, there is likely to be a material impact on global oil supply; the latter’s 2.4 million barrels per day of exports in 2017 is set to fall to about 2 million barrels. The predicted decline is lower than the 1 million-barrel drop seen in the last sanctions round in 2012, probably because there is less unanimity around the need for sanctions on this occasion, according to Mr Wittner. “We don’t think China will cut imports from Iran at all, and in Asia some allies of the US will cut while others may not. Turkey is unlikely to cut and the EU does not appear this time to be committed to cuts,” he says. “Still, the sanctions will likely have an impact on price.”

A key question is how Organisation of the Petroleum Exporting Countries (Opec) countries’ recent promise to boost production will play out. “Saudi Arabia and Russia have recently indicated that they, along with some other Opec members, intend to increase production to make up for lower output from Venezuela and the expected impact of sanctions on output from Iran,” says Mr Wittner. The big questions, he adds, are by how much they increase production and how quickly they ramp up. “We believe their increase will be gradual and cautious, and will initially focus on Venezuela, because the size and pace of losses from Iran is not known yet,” he says.

The price of oil is a key dynamic for the global economic outlook, and in particular for inflation. Investors have a range of options for expressing a view, from inflation swaps and oil futures, to equity derivatives on oil producers and downstream operators. The bond markets will be more or less affected by inflation, with faster inflation reducing the value of bonds’ fixed returns. Conversely, the price of default protection in the credit default swap market may rise. Inflation-watchers will likely keep a close eye on US gasoline, which accounts for just 3% of the weighting of consumer price inflation but 50% of the variability.

Taking inventory

Another key driver of oil is inventories, which, when tight, put the oil forward curve into 'backwardation', meaning near-term prices are higher than longer tenors. “Backwardation creates an opportunity to buy the near-term futures contract and roll into expiries, generating a roll yield,” says Michael Haigh, global head of commodities research at SG CIB. “When there are geopolitical tensions this kind of trade starts to attract attention, especially where you are expecting more backwardation, for example emanating from lower inventories as Iran exports drop.”

One limiting factor on the oil price, according to some analysts, is the impact of the fracking revolution in the US, which acts as a counterbalance to higher oil prices. As oil rises, fracking becomes more attractive and the US produces more, which has a depressing impact on the price of oil.

“The emergence of an alternative to Gulf crude through North American fracking and shale oilfields provides a natural break on oil prices,” says Tom Elliott, international investment strategist at deVere Group. “If oil is high for any length of time it encourages the US to increase fracking. However, it’s also worth noting that higher oil prices have less impact on Western economy gross domestic product growth than previously, due to the decline in manufacturing in those countries, so investors should bear that in mind.”

The view that higher oil prices will necessarily lead to more fracking is a matter of debate among analysts. SG CIB’s Mr Wittner points out that pipeline capacity limits in the US mitigate against a significant increase in fracking production.

Sector dispersion

Of course, the affects of geopolitical risk extend well beyond the energy markets, and equities are just as exposed, but not always in the same way. Certainly, faster inflation has the potential to prompt a rotation from bonds into equities, but there is also a more subtle impact of sector dispersion in the equity space, with bond proxies such as utilities often doing less well and higher beta stocks such as autos, industrials and mining tending to improve.

“The sector dispersion context plays well into the theme of geopolitical uncertainty, where there can be an impact on a particular sector, such as steel in a trade war, or a particular commodity,” says Kokou Agbo-Bloua, global head of flow strategy and solutions at SG CIB. “You can make money if you have sector rotation, so that, for example, you buy volatility on single stocks and sell on an index. If some stocks go up and others go down, the index volatility is in aggregate low while the single-stock volatility is high.”

Another manifestation of geopolitical risk affecting the market is when an individual country has a specific problem. Italy, for example, has experienced political uncertainty following recent elections, creating an opportunity for investors to bet that the government is unlikely to default (given the proven willingness of the European Central Bank [ECB] to act as a backstop). Meanwhile financial institutions may be subjected to selling pressure, perhaps leading to rights issues and pressure on equities, or more demand for option protection.

“Before the ECB intervenes to prop up financials, you may see a dislocation, with equities likely more impacted than credit and you could, for example, take a position,” says Mr Agbo-Bloua. Another way to express a view on specific risks is through thematic baskets. “Over the recent period there has been rising client interest in taking positions on baskets of stocks that would be vulnerable to trade wars and rising interest rates in the US,” adds Mr Agbo-Bloua.

Euro pressure

According to deVere’s Mr Elliot, the troubles in Italy are a microcosm of the wider popularist trend that has played out in the US and UK, which narrowly voted to leave the EU in 2016. “All of these events are part of the same trend, which is a move toward unilateralism,” he says. “In Europe, you have to worry because there has been a failure to achieve a banking union, and without that you can’t have a fiscal union. In short, Germany doesn’t want to be responsible for Italian liabilities, which means that the euro is going to stay under pressure.”

One of the challenging aspects of formulating investment strategies for geopolitical risk is that many of them never materialise. There is certainly ample evidence to suggest that a policy of using the options market to hedge every risk is likely to lose money. “There is always something on the horizon that may be big, and on a daily basis we see pronouncements coming from the White House. So you can spend a lot of time looking at potential risks, and often it turns out just to be noise or markets take it on the chin and rebound in a very short time,” says Lukas Daalder, chief investment officer at Robeco’s Investment Solutions. “Having said that, we do have these conversations on a weekly basis and we have recently taken a short position on the euro against the dollar, at least partly because of the Italy situation.”

In assessing geopolitical risk, one complicating factor is that the same risk can have a different impact depending on its context. “Already we see this year that the same kind of geopolitical events are having a bigger impact than they did six months ago,” says Thierry Apoteker, CEO of economic risk consultancy TAC Economics. “There has been a regime change between last year and the first months of this year, in which volatility is higher and in that environment any geopolitical news flow will have a much bigger impact.”

With that in mind, Mr Apoteker says that geopolitical events in 2018 – during which time economic fundamentals are expected to remain relatively strong – will have less impact than going into the second half of 2019, when a cyclical economic reversal in the US becomes much more likely. “If higher rates slow the US, which is our prediction, then geopolitical events start to look a lot more menacing,” he adds.

Positives and negatives

A related point is the position in which investors find themselves when geopolitical events occur. In a good year, the risk of higher inflation or an equity downturn may appear relatively benign, while from a position of weakness it can be overwhelming. “If you are at plus 8% and some risks drop you to 5% then you are still in a positive year,” says Robeco’s Mr Daalder. “But if you are flat and there is the risk of the same drop it could put you in negative territory, which causes a lot more nervousness.”

To help portfolio managers gauge the impact of geopolitical risk on markets, BlackRock recently launched a tool that scrapes relevant mentions from newswires and social media feeds, and produces a measure expressed as a deviation from the long-term average. “There is a view that geopolitical risk doesn’t matter, and historically that is true – it moves the markets for five days and everything goes back to where it was before,” says Isabelle Mateos y Lago, chief multi-asset strategist at BlackRock. “Still, not all shocks are created equal and studying the long history since the Second World War, the ones that change people’s outlook for growth have more impact.”

According to SG CIB’s Mr Agbo-Bloua, an important strategy is not to chase geopolitical risk, which invariably leads to panic decisions, including selling at the bottom or buying at the top. A better approach is to trade ‘the noise’, aiming to profit from second-order impacts. He believes investors should consider volatility dispersion trades or relative value trades, aiming to capture the dislocation rather than making a bet one way or another.

“Of course, it’s also important to be aware of the context,” he says. “For example, the fact that US equities are supported at present by a buyback phenomenon, which will only continue as long as the earnings yield is higher than the after-tax marginal cost of debt, because a lot of buying is funded by credit. As interest rates rise, and the cost of credit goes higher in the coming period, that may change, and that vital support will evaporate.”