Should Investors Be Concerned About Rising Geopolitical Tensions?

Yes, but positioning for such risks is challenging as timing and specific circumstances are uncertain. Investors should rely on their usual lines of defense: portfolio diversification and liquidity provisioning.

Geopolitical conflict is on the rise as China and Russia seek to expand their regional power, much of the Middle East is in crisis, and European Union institutions are being tested. Much of Eurasia is facing a range of political, economic, and social risks. Against this backdrop, China and Russia have increased military near misses and cyberattacks aimed at the United States and its allies, which to date have failed to elicit US military retaliation.

Nothing appears likely to prevent these regional conflicts from escalating, nor is there a clear reason to believe that US engagement will be more substantive than it has been in recent years. The United States—the world’s only superpower—has stepped back from its role as hegemon to rely more on local powers, rather than engage in on-the-ground combat. To quote a recent report from Geopolitical Futures, founded by George Friedman, formerly of Stratfor, “There is nothing to stop the momentum of these crises. The global order is poised for a major reconfiguration. That will not necessarily mean a new world war, but the possibility of war cannot be dismissed.”

If the 1990s was a period of rising “peace dividends”—as the fall of the Soviet Union led to a decline in global conflict, accompanied by falling inflation and less volatile markets—the current period can be thought of as a period of rising geopolitical risk premiums. Indeed, US equities now trade at a 60% valuation premium to other developed markets, well above the post-1972 average of 10%. Such a premium is, in part, attributable to the relative distance the United States enjoys from geopolitical strife. Investors should factor in this dynamic when sizing US equity allocations. Underweights should be modest in recognition of the relatively defensive characteristics of US equities in times of stress.

Investors also need to consider geopolitical risks when stress-testing portfolios to determine how much defense to incorporate. In a challenging capital markets environment of somewhat elevated equity valuations and ultra-low sovereign bond yields, investors must balance seeking out attractive prospective returns to earn what they spend and maintaining diversification even in the face of today’s expensive defensive assets. We recommend investors revisit defensive portfolio positions, holding the bare minimum of sovereign bonds (outside of those hedging long-dated liabilities) and seeking out more diversifying hedge funds, as well as often-overlooked trend-following strategies as a second line of portfolio defense. Cash can also be appropriate as a liquidity reserve in a variety of environments, particularly as part of a barbell portfolio strategy that includes owning more higher-expected-return assets. Such revisions to the defensive portfolio should reduce return drag while still providing diversification to equity risk.

Investors should also make sure they have adequate liquidity to support future spending needs and capital calls, as well as to rebalance. Additional considerations relate to the potential for debt covenants to be violated or credit ratings to deteriorate during major market declines, geopolitically driven or not. Such an analysis should be evaluated holistically, not just focused on resources inside of the long-term investment pool.* The key objectives are to understand both how long portfolio liquidity will last (given cash flow needs, current asset allocation, and performance) and how the liquidity composition of the portfolio may change over time. This analysis should also be paired with an assessment of the cost of increasing portfolio liquidity. In fact, it is possible to have too much liquidity, and an important objective of liquidity management should be to minimize cash needs by closely monitoring liquidity sources and uses and by planning ahead.

In an environment of low growth, low sovereign bond yields, and elevated valuations, capital markets are unlikely to deliver most investors’ long-term return objectives over the next five to ten years. While it may be tempting to boost returns by eliminating defensive assets, investors need to make sure they have appropriate belts and braces to withstand any sort of shock, including those from rising geopolitical risk. Portfolio construction can be improved to minimize use of expensive sovereigns, relying more on diversifiers such as trend-following strategies and more defensive hedge funds; use of cash, paired with inclusion of higher risk assets, can improve returns while maintaining defensive positioning.

* Please see Mary Cove et al., “A Holistic Approach to Liquidity Management,” Cambridge Associates Research Report, 2016.

Celia Dallas is Cambridge Associates’ Chief Investment Strategist.