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Brian Andrew, CFA

Strategic Patience

Last week, Vice President Mike Pence used the phrase “strategic patience” to describe the U.S.’s former foreign policy toward North Korea. These words may also reflect the way investors need to think about geopolitical events and their investments.

Geopolitics

While global politics are always a factor in investing, they often remain at the back of investors’ minds as we focus on economic and individual company fundamentals. We often discuss the pace at which an economy grows, whether inflation is rising or falling, and how the unemployment picture looks. When describing our view of companies’ stock and bond prices, we generally focus on revenue and earnings growth, cash flow generation and the soundness of balance sheets. However, geopolitics always lurk in the background, ready to upset our view of the aforementioned fundamentals.

Occasionally, like now, geopolitics appear front and center, causing disruption in markets, reminding us that we must understand the potential impact and the effect on our view of portfolio construction. It can be challenging to think about how these events affect the value of the assets we own, and more importantly what the long-term impact might be.

Geopolitics and Its Effect on Markets

Geopolitical events have the ability to roil markets in short–order (see graph at end). The impact of a surprising outcome in last year’s U.K. Brexit vote is a perfect example. U.S. and global stock prices declined by over 6% and 8%, respectively, in several sessions and then recovered their previous levels in the two weeks that followed. There are two things about the Brexit event that provide insight into the way geopolitical events effect the markets. First, the outcome of the vote was somewhat surprising. A surprise event generally leads investors toward immediate risk reduction. Markets had positioned themselves for a different outcome and, when surprised, investors reduced risk in their portfolios by selling stocks and increased their holdings of safety assets like U.S. Treasuries, pushing those prices higher. Second, the time horizon of the geopolitical event’s impact on fundamentals will affect the markets’ outcome. As investors determined that the vote would not turn into action for years, markets increased risk and moved back to prior positioning. This week, U.K. Prime Minister Theresa May announced an election on June 8 that just a week ago she indicated would not happen. Markets were surprised and currency values moved. It seems she did this to consolidate her party’s power in Parliament ahead of the Brexit negotiation. However, the Brexit negotiation is still just beginning, and its effect can’t be completely understood until further along.

Current Events

The conflicts in Afghanistan and Syria and the tension on the Korean peninsula have been headline news in the last several weeks. Most importantly, the current administration has been telegraphing a different foreign policy approach than the predecessor, which suggests the potential for a surprise event is higher. In the face of this news, stock and bond market volatility have moved higher. However, these events don’t appear to affect economic fundamentals in the short–term. Corporate fundamentals for defense–related companies have changed both as a result of the administration and Congress’ desire to increase defense spending and because this new foreign policy suggests that the national security and defense complex may increase in size and reach. How exactly this will play out takes time, which is why patience is required.

The upcoming April 23 French presidential election is another example of how geopolitical events can shape markets. Investors have been discussing the rise of populist votes since the Brexit vote in June of 2016 and the U.S. election last November. In the case of France, there are four candidates running close to one another with very different views of how the country should move forward. Depending upon who wins the election, concerns about a French exit from the European Union could upend currency and stock markets further. The two winners will face off on May 7, so this issue will be with us in the near future.

Understanding Risk

We routinely evaluate risk in our portfolios relative to the exposures we have to risk assets (stocks, bonds, and real assets) and the market segments of those assets (large versus small company, domestic versus international, emerging market, sovereign versus corporate debt, etc.). We also regularly discuss geopolitical events and the potential impact on asset prices and the overall level of risk we are willing to take in portfolios. We evaluate these events based on the real impact they may have on economic and corporate fundamentals as well as the time horizon over which that impact may occur. Using this information, we position portfolios accordingly.

We may also consider how a dislocation in asset prices due to a surprise geopolitical event can be used to our advantage. As an example, if a surprise event leads to a flow of money into safe–haven assets such as Treasuries and it appears the impact of that event will be short–lived, then we may take advantage of the rise in Treasury prices to reposition portfolios. At the same time, this sort of event (like Korean tension) can lead to a reduction in risky asset prices, such as stocks, and could provide an opportune time to increase our allocation. The key is understanding the event, the time horizon of its impact, and the likelihood that it will alter economic and corporate fundamentals.

We believe this is an important part of our investment approach and employ both external and internal research resources to evaluate geopolitical events on an ongoing basis, not just when they make the headlines. While the administration may be moving away from “strategic patience” on the Korean peninsula, we understand that it must be a part of how we invest.

Given our outlook for modest economic growth this year and a slowdown in the year–over–year increase in inflation, we view higher interest rates as a policy change reflecting the Fed’s acknowledgment that the economy doesn’t need extraordinary measures any longer, not because growth is taking off but because it’s sustainable at these levels.

All in all, the first quarter of the year was a positive one for balanced investors. Stocks and bonds rallied as investors discounted the news that the Fed was returning to normal, fiscal policymakers were likely to reduce regulation and cut both corporate and individual taxes, and corporate earnings were finally rising due to some revenue growth. Of course investors will continue to keep an eye on policymakers’ progress and, if disappointed, adjust prices accordingly. Let’s hope policymakers don’t deliver a Midwestern–like April!

 

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Views and comments expressed in this blog are those of the author and do not necessarily represent the positions of Cleary Gull or fellow Cleary Gull associates.