T.ALK TO THOSE You regularly buy and sell financial assets in the world’s trouble spots and soon encounter a recurring source of irritation. Everyone is an expert. The prospect of conflict turns any knowing spreadsheet jockey into a military strategist or Kremlin observer. Buttonwood shares this outrage on behalf of newspaper columnists everywhere. Making bold statements based on a little knowledge is our bat. Please go on. We are already working on this corner.
Right now there is enough to occupy the general of the chair. Geopolitical risk is rising after a pause for the pandemic, concludes a recently published paper by BCA Research. Three protoconflicts in particular hit the headlines and test the resolve of the new administration in Washington. Russia has deployed enough troops to stage new incursions into eastern Ukraine. Iran has stepped up its nuclear program to the wrath of Israel. And China is conducting threatening exercises around the island of Taiwan.
An escalation of these tensions can push the markets sideways. And it’s tempting for investors to try to anticipate a flare-up to reap “geopolitical alpha,” the excess returns from conflict-related risks. By and large, the temptation should be resisted. Successfully trading geopolitics is a lot harder than it looks.
Perhaps the most seductive idea to fight back is that you have some expertise. Real experts are not in short supply. Almost everyone who has spent time at the State Department or as a national security advisor appears to have set up a consultancy. But there are pitfalls for the unwary, as Marko Papic of the Clocktower Group, an alternative investment firm, argues in his book “Geopolitical Alpha”. The first thing to remember is that former intelligence agents no longer have access to classified intelligence agencies. Be especially careful with convincing views, says Papic. Consultants tend to exaggerate the likelihood of the worst outcomes as this is a great way to showcase their insights. A real expert will be prudent, setting out scenarios and determining the factors that you need to monitor.
In fact, few geopolitical events have a lasting impact on stock markets. As Mr Papic shows in his book, the pattern from the 1962 Cuban Missile Crisis onwards is that a short-term decline in the American stock market is followed by a rally the following year, which is often quite strong. The Yom Kippur War and the subsequent oil embargo are an exception. But in general the markets are regaining their stance. The economy goes on. From this we could approach the germ of a useful trade rule. The best way to capitalize on geopolitical risk could simply be to act against the excessive fears of others.
At the beginning of a geopolitical crisis, events move faster than you can trade them. You read about tensions in the Middle East. So you are buying oil futures. But algorithmic traders will beat you to the limit. You could follow the escalation. But now you’re more of a momentum trader than a geopolitical risk trader. And sometimes there isn’t an obvious trade to take – or the seemingly obvious trade makes no sense. When North Korea stepped up its missile testing in 2017, a popular trade was to buy credit default swaps, a form of insurance, for South Korean national debt. But you might reasonably be wondering if a debt default in the event of a nuclear strike would really be your main concern.
If you opt for oversold assets instead, there are still a few more considerations to make. For example, you might decide that Russian assets are cheap. The problem is that tensions between Russia and America could easily worsen. If you want to “buy the dip” this way, you should have a theory of how things could ultimately be resolved based on informed judgments about what each party to the conflict wants and what political and economic constraints they have. You would need to map the potential flashpoints from here to there. If you feel that a conflict cannot easily de-escalate, it may be wiser to stay away.
In geopolitics, a little knowledge can be a dangerous thing. However, investors cannot be completely agnostic about the wide range of international relationships. The long boom of the 1990s cannot easily be resolved from the fall of the Berlin Wall. China’s accession to the World Trade Organization in 2001 ushered in a commodity super cycle. Avoid the narrow space of the typical spreadsheet jockey. But beware of the geopolitical strategist in the armchair – especially if you are.
This article appeared in the Finance & Economics section of the print edition under the heading “The Art of War”.