Although stock markets have moved higher since the U.S. presidential election, the growing number of headlines focused on unrest in places like Syria and North Korea has some investors thinking they should head to the sidelines with their equity exposure. Nobody enjoys rising volatility, but trying to time the markets’ reaction to geo-political events is very difficult and risky.
Perhaps more to the point, geopolitical conflicts have been present throughout investment history and, as we will highlight in this issue of Our Perspective, have generally not provided a good reason for investors to reposition their equity investments into cash. Many times, markets react negatively for a short period of time, but soon correct and resume their otherwise upward trajectory.
At Sage, we take into account the potential for periods of geopolitical instability upfront when analyzing how to construct our diversified portfolios. We encourage our clients to stay off the sidelines and keep their focus on the long-term with their equity investments knowing their portfolios are built to withstand some volatility.
What We Know
- The Trump administration appears to be taking a more aggressive approach to foreign policy than the Obama administration as evidenced by its decisions to launch missiles into Syria and to issue a verbal challenge to North Korea. Though Syria and North Korea are minor players on the global political and economic stage, the involvement of Russia and China in each area, respectively, very well may have greater implications for global trade and market movements.
- Although no two sets of circumstances are ever the same, it’s helpful to look at some historical geo-political events and compare how the market responded to them. The Cuban Missile Crisis, for instance, saw the U.S. face a clear risk of nuclear war with Russia by engaging its proxy state of Cuba. According to Bloomberg, the Dow Jones Industrial Average fell 1.2% during the height of the crisis in October of 1962, but it rose 10% in the final two months of the year after the dust settled a little bit.
- In March of 1965, the U.S. sent troops into Vietnam. From that point until troops were pulled out of Vietnam in 1973, the market rose 43% cumulatively, or 5%, annualized.
- When the Gulf War started in August 1990 following Iraq’s invasion of Kuwait, the S&P 500 Index fell 5.71% from August through the end of the year. In the following calendar year (1991), however, the S&P returned 47%.
- After the U.S. launched missiles into Syria this month, stock markets pulled back modestly, with the S&P falling around 0.6% (from April 7th to the 18th). International large cap stocks have declined around 0.3%, and emerging market stocks have fallen around 0.5%. Though the short-term future is uncertain, we still believe global equity markets are poised for positive long-term returns in spite of political risk.
- Historically, stock markets have experienced some volatility at the onset of geopolitical tensions; however, the volatility is often modest and short-lived.
- As the three instances we reference above illustrate, the U.S. stock market has moved on quickly from whatever the headline risk of the moment was, even if the events transpired over multiple years (like the Vietnam War).
- It can be tempting for investors to try to time these geopolitical events because of their initial emotional response. But the Brexit referendum in the United Kingdom last year provides a great lesson about how investors should not necessarily assume the worst and react to the short-term political noise.
- Someone who feared the worst with Brexit would have technically been correct in assuming that markets would react to the downside. However, getting the immediate market reaction right is not enough. It is also necessary to know exactly when to get back in. While there was a sharp drop in equity prices in the days after the referendum, markets rebounded very quickly and rallied for the rest of the year. Investors who sought safety on the sidelines only had a few days to jump back into the market. Similarly, with the U.S. presidential election, the overnight losses in stock market futures were effectively erased by the end of the next day.
- The primary takeaway here is that trying to time geopolitical events by waiting on the sidelines is incredibly difficult. Investors are best served by acknowledging the potential for increased volatility while admitting that it is impossible to know both the degree to which markets may sell-off and the point at which they may rally back.
- A fundamental goal of diversification is to build a strategy that succeeds over time despite temporary volatility and allows investors to remain in the game and off of the sidelines.