Investing amid geopolitical tension
Last week, stocks slid and posted relative large losses when compared to 2017's tepid volatility. The drop on Thursday of 1.45 per cent for the S&P 500 was actually the largest drop since May of this year. Ironically, in a longer historic context, the slide we are seeing is not that large in magnitude.
The key reason for the slide, of course, is geopolitical tensions regarding North Korea. The world is increasingly becoming more concerned and fearful of a full out conflict with the US and its allies against North Korea. The United Nations Security Council's unanimous decision to enforce stricter sanctions has caused Kim Jong Un to release retaliatory commentary.
The key risk in this conflict is obviously South Korea which would likely witness a retaliatory strike from North Korea if there was pre-emptive action taken by the US.
In terms of the global economy, South Korea may be surprisingly large in influence. According to Bloomberg Intelligence (BI): “At $1.4 trillion, South Korea's GDP is equal to 1.9 per cent of the global total … The picture on trade is equally stark, with South Korea accounting for 3 per cent of the global total”.
BI compares this to another major military skirmish, Iraq, which in comparison contributed virtually nothing to world GDP and only 0.1 per cent to global trade.
South Korea is home to some of the world's major electronics and auto exporters such as Samsung and Hyundai Motors. Obviously, if South Korea is engulfed in the conflict, which would seem unavoidable due to the large US troop presence on the northern border, we would likely see disruption in the global supply change for a series of products. So South Korea is slightly more important, economically speaking, than some of the more recent countries involved in military conflicts in recent history and more integrated with our global economy.
While skirmishes in the Middle East affect oil prices, any major future conflict in the Asia/Pacific region would be hard to gauge in its ultimate effect given little recent historic examples. Thus uncertainty is rather high in regards to the outcome and the markets globally have responded with increasing volatility.
The reality is a North Korean War would likely be devastating in its ferocity but very one-sided. The North Koreans do not have the resources to carry out a prolonged conflict with the rest of the world and they have few friends to join their fight.
It's important, at this stage, to pause to reflect on what has typically transpired. The market is very fickle in regards to geopolitical events. History is marked many times over when geopolitical events cause market sell-offs only to rebound shortly after the event passes.
One may want to simply review the latest effect of Brexit, the supposed “guaranteed sell-off” that a Trump victory would bring or even the demise of the financial system during the Great Recession.
It's also worth noting that prior periods of military conflict also have mixed reactions. Ben Carlson, in a post “How Markets Respond to Geopolitical Crises”, from “A Wealth of Common Sense” details some interesting historic market reactions in times of geopolitical stress.
To quote: “In the six months following the onset of the First World War in 1914, the Dow dropped more than 30 per cent. That year, the stock market closed for six months, the longest it has ever been shut, because liquidity all but dried up.
“But in the following year, it rose more than 88 per cent, which remains the highest annual return on record for the Dow Jones Industrial Average.
“The Korean War began in the summer of 1950 when North Korea invaded the South. That conflict ended in the summer of 1953. In that time, the Dow was up an annualised 16 per cent, or almost 60 per cent in total.
“The Cuban Missile Crisis had the world on the brink of nuclear war in October of 1962. The confrontation lasted 13 days from October 16, 1962, to October 28.
“In that two-week period the Dow remained surprisingly calm, losing just 1.2 per cent. For the remainder of that year the Dow would gain more than 10 per cent.
“The US invaded Iraq in March 2003. Stocks rose 2.3 per cent the following day and finished up the year with a gain of more than 30 per cent from that point on, though this followed the end of a brutal bear market.”
Geopolitical predictions are hard to make but gauging the market's reaction to them may be even more difficult to fathom.
It's also worth noting that you can't really be an investor if you are overly pessimistic. For example, if you are chronically bearish you are basically betting against humanity — you would appear to believe that the billions of people who go to work every day across the globe for various excellent companies and businesses are not doing so to make things better.
This is not to say that this current round of geopolitical fears will not materialise in a negative fashion. I am only suggesting that, in the longer run, we are a progressive species. Besides a prudently managed portfolio should contain some assets that hedge negative outcomes and/or offer liquidity to take advantage of dislocations.
The current reality is that corporate profits in the latest quarter are up more than 10 per cent in the US and margins continue to expand. Maybe more importantly, is that 2018 earnings estimates have actually remained steady at about 11 per cent growth for next year when historically we see downward revisions over time.
I don't want to sound cavalier and downplay war and conflict, its impact is worrisome and detrimental to society, but we need to also remember that the majority of the world wants to move forward. Periods of dislocation offer opportunities for those willing to act dispassionately and rationally.
I will leave you with one other thing to theoretically ponder. If the market is selling off rapidly on the imminent threat of an all-out global nuclear war, should you sell?
I would suggest the answer is no. In fact you are likely better off buying aggressively. If the threat doesn't materialise the market will most likely abruptly turn to the upside and reprice very positively.
If the threat is real … it doesn't really matter what you've done.
Sources: “Asia's Security Risks: Economic & Market Implications”, Bloomberg Intelligence Economic Research, Global Dashboard.
“How Markets Respond to Geopolitical Crisis” by Ben Carlson, A Wealth of Common Sense, June 14, 2017 (on the web: goo.gl/LZ89fA).
Nathan Kowalski CPA, CA, CFA, CIM is the chief financial officer of Anchor Investment Management Ltd and the views expressed are his own.
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