For long-term investors, facing periods of geopolitical risk is unavoidable. Headlines on regional and global conflicts can be alarming since they disrupt the typical flow of business and market news. These events are also difficult to analyze and their outcomes challenging to predict. Of course, this doesn’t stop many short-term traders from talking about “buying the invasion,” betting on oil prices, and trying to time the market. Nor does it stop market strategists from making bold predictions about how the S&P 500 might react. So how should long-term investors react in the face of geopolitical conflicts today?
Recent events concerning Russia and Ukraine are definitely troubling. On the surface, Russia is seeking to assert its claim to the Russian-controlled regions of Donetsk and Luhansk, with their forces now entering the region after weeks of build-up and intelligence warnings. Like the 2014 annexation of the Crimean Peninsula by Russia, these moves violate the sovereignty of Ukraine. The US, Europe, and NATO allies have responded with plans for sanctions and their own military action. Germany has also placed approval of the Nord Stream 2 pipeline, which would carry Russian natural gas, on hold. Knowledgeable observers understand that, in reality, the true motivation for Russia goes beyond the two statelets. It is the most recent response to decades of tension beginning at the end of the Cold War.
The current situation only adds to the many geopolitical crises this century. These include: the September 11 attacks , the war in Iraq, the “Arab Spring”, Russia’s annexation of Crimea, periodic North Korean missile crises, tensions between China and the US, the aftermath of the US’s exit from Afghanistan last year, and many more. While each of these episodes is geopolitically impactful, their implications for long-term portfolios are not always clear.
This is because, while markets may react to a variety of news on a daily and weekly basis, what drives portfolios over years and decades is quite different. Over longer periods of time, slow and steady economic growth, corporate performance, and valuations matter most. This was true during the conflicts mentioned above as well as in the decades following World War II and during the Cold War.
Events such as 9/11, as well as the wars in Iraq and Afghanistan that followed, were certainly met with market declines. These pullbacks, however, coincided with the dot-com crash which was entirely unrelated. Conversely, various conflicts since the 2010’s — including multiple civil wars in the Middle East, Crimea, and the on-going nuclear threats in North Korea and Iran — took place against a backdrop of a strong economic cycle. And while short-term market uncertainty occasionally accompanied these events, it was the business cycle that ultimately drove stock returns.
Energy prices are perhaps a case in point, since many of the above-mentioned conflicts have tended to involve oil and gas producing regions. This is true currently, with energy prices rising steadily as Brent crude approaches $100 per barrel. As a member of OPEC+, Russia is an important supplier of oil and natural gas to many parts of the world, notably Europe. That said, energy prices had already been rising steadily throughout the pandemic recovery and in response to lower-than-expected OPEC+ production. During the 2014 episode in Crimea, there was little direct impact on oil, and even the 2019 drone strikes against Saudi Aramco by Iran and others, which knocked out 5% of global oil production overnight, saw only a short-lived reaction in oil markets. Thus, the direction of energy prices can be difficult to predict.
The economy and cash flows are obviously not the only factors that affect stock prices. Markets depend on global stability, the rule of law across regions, and business/consumer confidence. Regional conflicts that could involve the United States and its allies can increase the “risk premium” – the discount rate we use to value future cash flows. In theory, even if corporate profits and cash flows are unaffected, the possibility that they could be affected is enough to hurt investor confidence and stock prices. After all, if the world does destabilize, cash today is worth much more than the promise of cash far out into the future.
That said, experience teaches that it is probably unwise to make dramatic shifts in portfolios in response to a budding geopolitical crisis. Properly diversified portfolios, especially those built around long-term financial plans, are designed to handle these periods of uncertainty. And it is always the case that markets can swing wildly at any moment, whether it’s due to political events, economic shocks, or a myriad of other proximate causes.
None of this is to dismiss the severity of the current situation in Ukraine from a geopolitical, humanitarian, or regional economic perspective. While these issues will be closely watched, investors should consider these events in a broader economic and market context. Below are three charts that help provide perspective on how geopolitical events affect investors.
1. Geopolitical events can startle markets in the short run.The history of geopolitics and the stock market is mixed. In the long run, markets tend to recover and perform well, primarily because business cycles are what matter over years and decades. In cases like 9/11 and the ensuing wars, markets were down because of bear market conditions already in place.
2. Oil prices have been climbing throughout the recovery. Oil prices have been recovering steadily since they collapsed at the start of the pandemic. While regional conflicts can affect energy prices, history shows that this is neither guaranteed nor are there always long-lasting effects.
3. The stock market has grown despite a century of major conflicts.The past century witnessed several major global conflicts including World War II, the Vietnam War, and the on-going tensions of the Cold War. Throughout these periods, the economy and stock market were able to grow steadily. For long-term investors, overreacting to these events would have been the wrong move.
If you have questions about your own portfolio, or wish to review your risk level, please reach out to your Griffin Black wealth advisor.