Managing Risk Amid Geopolitical Uncertainty

Given the war in the Ukraine, I thought it would be helpful to provide insights for advisors and investors to think about risk and what if any actions should be considered. I begin by noting that the historical evidence demonstrates that geopolitical risks affecting markets are a fairly frequent occurrence.

There’s an old curse that goes, “May you live in interesting times.” Like it or not, we are now living in interesting times – times of danger and uncertainty. There is no downplaying the frightening news from Ukraine over the last week. Compounding the problem is that investors already had much to worry about: equity valuations at historically high levels (the Shiller CAPE 10 ratio began the year at 37.5, a level only exceeded once when we approached the end of the tech bubble); the S&P 500 “correction” of almost 12% between January 3 and February 23, 2022; interest rates on bonds at historically low levels, with real rates on safe bonds at significantly negative levels; inflation increasing at a much faster pace than most (including the Federal Reserve) expected and showing signs that it’s not transitory; and concerns over the massive increase in the federal debt, causing the debt-to-GDP ratio to rise above 100% (and the implications of that for future economic growth).

The increased uncertainty of both geopolitical and economic risks results in a significant widening of the potential dispersion of potential outcomes (with the tail risk increasing both in width and depth). As one example of how the potential dispersion of risks has increased, in his Marginal Revolution analysis on the Ukraine situation, Tyler Cowen stated: “Russia has to win fairly quickly, or these and other forces will increasingly work against it. Ukraine thus can fight for a military stalemate, but Russia cannot. The Russian forces must take increasing levels of risk, even if those risks have what decision theorists call ‘negative expected value’ – that is, they serve as desperate gambles and on average worsen the Russian situation. Of course, that makes the war increasingly dangerous, and not just for the Ukrainians. If Putin is afraid the forces in the field won’t always carry out his orders, for example, he may order the launch of 10 tactical nukes rather than just one.”

Thanks to the research team at J.P. Morgan, we can examine the impact on markets of the last 12 major geopolitical events that led to volatility, going back to the Arab-Israeli War/oil embargo of 1973. That was one major event about every four years on average. Thus, investors should consider that such “black swan” events are normal and should be built into plans (we just don’t know when they will occur or what will be the cause). With that said, the evidence suggests that these events have led to short-lived volatility, with the average market sell-off caused by geopolitical events of only about 6.5% and just 12 days duration, and the average time to recovery of about 137 days. The longest duration was just 27 days (the 1973 Arab-Israeli War/oil embargo) and caused a sell-off of 17.1%.

History doesn’t always repeat, and people can drown in a stream with a depth of just a few inches. In other words, this time might be different, with the duration longer and the sell-off steeper. Investors should be prepared for that possibility – especially given the high level of valuations of some U.S. stocks (particularly growth stocks).