Armed conflict investor survival guide

If you read this, another geopolitical event has triggered fears in financial markets. In this note, I provide a simple checklist to help investors make sense of the events from a fundamental perspective. Based on the evidence from dozens of empirical studies I provide a list of questions to answer and how to position portfolios in reaction to these answers.

A guide to help investors separate the signal from the noise

We live in a world where wars, civil strife, and geopolitical tensions have an increasing influence on markets. There are plenty of geopolitics consultants ready to help investors with advice and even more strategists who pretend to know how to play markets in a time of geopolitical tensions.

Geopolitical risk index

Source: Caldaro et al. (2021)

Yet, in my experience, the vast majority of these pundits peddle in doom and gloom that makes for great headlines but is usually bad for investment portfolios. Drawing on my book on geopolitics for investors available for free at the CFA Institute website,[1] I provide a survival guide for investors on how to react to geopolitical crises.

This survival guide is not specific to any particular crisis at hand but based on an analysis of the extensive empirical literature on the impact of wars, civil wars, terror acts, and similar events. Also, I will only deal with stock markets here, rather than the many different asset classes that feel the influence of a geopolitical event. Evidence-based investors should use this note as a guide during the hectic and often irrational market phase following a flare-up of geopolitical tensions to separate the signal from the noise.

Don’t panic (inscribed in large friendly letters)

The most important rule for investors to heed in response to a geopolitical crisis is not to panic. The evidence is extremely clear on one thing: the vast majority of geopolitical events do not matter for equity market performance over investment horizons of one month or longer.

So, repeat after me: Don’t panic. And resist the urge to sell stocks in a rush. On average, the correct response to a geopolitical crisis is to buy risky assets as they sell off.

The knee-jerk reaction of investors to geopolitical crises is to extrapolate the most recent events into the future and expect an escalation of a new conflict. This is when geopolitical experts[2] are on TV and in the press with their predictions of World War III or a 1970s style oil shock and stagflation, etc.

Ignore those warnings and doom and gloom forecasts as in most cases they are based on an assumption that the crisis rapidly escalates and gets out of control. However, that rarely happens. Over the last 150 years we have seen only two instances where wars got out of control. They are called World War I and World War II.

But we have seen hundreds of instances when a war broke out that could conceivably trigger World War III but hasn’t. Think of the Korean War and the Vietnam War, the Cuban Missile Crisis, the many wars in the Middle East or the constant tensions between a nuclear armed North Korea and its neighbours. Think of the many civil uprising during the Arab Spring of 2011. Yet, things rarely get out of control because, well, people like to live in peaceful times and will do their best to avoid going to war. It requires staggering miscalculation on both sides to escalate a war. One crazy dictator is not enough. It requires two of them or one crazy dictator plus appeasement on the other side.

A step-by-step guide to navigate geopolitical crises

Hopefully, you have managed to reduce your heart rate and blood pressure as you read these lines (remember: don’t panic). Now it is time to analyse the situation and act accordingly.

Question 1: Is the infrastructure of the country you invest in damaged or destroyed (e.g. are harbours or railways out of service, is the communication network impaired, etc.?)

If no, move on to the next question.

If yes, this is bad news for the local economy. It will likely mean a significant impairment of GDP growth and thus earnings growth for impacted companies. The companies running the damaged infrastructure will sell-off and it will take a long time to recover these losses. But don’t forget the insurers and re-insurers who must pay for insured damages (unless force majeure is declared, which may not always be possible). On the other hand, there are opportunities for companies that repair and rebuild the damaged infrastructure such as construction companies, telecom, and technology hardware, etc. Overall, however, it pays to move into defensive sectors like healthcare and consumer staples which have more resilient earnings growth in an economic slowdown.

Question 2: Is there a persistent (i.e. more than a year) impact on inflation and inflation expectations (e.g. there is a significant disruption in global oil and gas supply or a country is spending large sums to finance a major war)?

If no, move on to the next question.

If yes, invest in companies that benefit from higher inflation or produce the things that are in high demand. This means oil & gas companies in the case of an oil shock or defence contractors in the case of increased government spending on war efforts, etc. Gold miners can also benefit indirectly from these developments. Meanwhile, avoid companies with low profit margins and high sensitivity to input cost pressures, such as consumer goods and most industrials. Prefer companies with lower financial leverage and stable earnings that can better deal with possible rate hikes by central banks or cutbacks in investment and consumer spending in reaction to higher inflation. Examples are pharma, utilities (especially regulated utilities), tobacco, or essential consumer services like communication services.

More generally, inflation rates used in a discounted cash flow model should be higher while earnings growth expectations should be lower as profit margins are compressed due to higher input costs.

Note: Equities are often sold as ‘real assets’ that provide inflation protection as earnings adjust to higher input costs. This is not true for inflation rates above c. 4% because then businesses are typically unable to pass on higher input costs fast enough to end customers and face lower profit margins and a decline in earnings growth.

Question 3: Is there a persistent (i.e. more than a year) impact on real rates (e.g. because central banks hike or cut interest rates of governments introduce means of financial repression to keep interest costs artificially low)?

If no, move on to the next question.

If yes, you are facing a permanent increase in the cost of capital and a slowdown in demand as higher borrowing costs significantly impact investment activity and consumer demand. This means large parts of the stock market are heading south and a bear market is likely. If governments impose financial repression, it will be particularly bad for banks and possibly insurance, but if central banks hike interest rates, it will be good for banks and insurance companies as their profit margins rise in the short term.

The name of the game is to become defensive but be vigilant about avoiding companies with high financial leverage and debt that needs to be refinanced in the next one to three years. Ironically, this can often mean avoiding classic defensive companies like pharmaceuticals or utilities as these companies often have lots of debt and high financial leverage. However, things need to be examined on a company-by-company basis.

More generally, real rates used in a discounted cash flow model should be higher while earnings growth expectations should be lower as profit margins are compressed due to higher cost of capital.

Question 4: Have you answered ‘no’ to all the previous three questions?

If no, what are you doing here? Go back to the questions above and start again.

If yes, buy risky assets! The geopolitical shock does not have a permanent influence on inflation, real rates, or earnings but instead only increases the risk premium on equities. Such spikes in risk aversion typically last a couple of days to a couple of weeks so investors should use the setbacks in risky assets to invest as much as they can justify.

Note that the initial setback after the 9/11 terror attacks lasted three weeks, and after the London bombings one day. The first setback after the Russian invasion of Ukraine lasted ten days at which point all losses were recovered. Only after this initial knee-jerk reaction did markets price in the expectation of permanent increases in inflation and started to decline again.

On average the best course of action is to buy risky assets

To repeat the key result of studies on geopolitical risks and their impact on stock markets: your default reaction should be to buy risky assets as they sell off temporarily.

Only if there is a lasting impact on inflation, earnings or real rates can one justify selling some stocks. But a lasting impact must be lasting. Share prices may react to the expectation for the next quarter or two, but that is just noise. Expectations must change for more than a year to have a significant and lasting impact on share prices.

As Ben Graham already knew:

“In the short run, the market is a voting machine but in the long run it is a weighing machine.”

When investors vote with their feet, it is time for the superior investor to weigh the evidence and act accordingly.

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[1] https://rpc.cfainstitute.org/en/research/foundation/2021/geo-economics

[2] Ironically, there are hardly any geopolitical experts with an investment background. Almost all geopolitical experts have a background in international affairs or political sciences and do not know how financial markets work. Meanwhile, during geopolitical crisis, many economists like to stylise themselves as geopolitical experts without having ever seriously studied the empirical evidence on geopolitics and financial markets or without ever having managed money successfully. We tend to think of them as ‘geopolitics tourists’ and who would take directions from tourists?