Taking on the World

Taking on the World

By:            Marc Bellefeuille MBA CFA FRM CFP

                  Zach Laleg CFA

                  Bright Bennett

February 24th,2023 marked the dubious anniversary of the invasion of the sovereign nation of the Ukraine. As if this was not enough for the world to be dealing with, relations between China and US sunk to new recent lows after a suspected spy balloon was shot down over US airspace raising tensions between the two world powers. As investors, this raises the question of what the impact of these risks will bring about and what could be done to address geopolitical risks more broadly within portfolio management.

In the context of portfolio management, striking a balance between risk and return is a paradox as old as time. Academic theories such as the efficient frontier postulate that the market has all relevant information on securities and that for any given level of risk there exists a return which compensates the investor appropriately for taking on said risk. Assets that do not plot on the efficient frontier are said to be missed priced and can therefore create opportunities for investors to profit from the mispricing. [i]Geopolitical events can often lead to market dislocations but whether that means assets are mispriced as a result is a whole other matter. Investors need a solid process for determining what to do when geopolitics enters the narrative of their investment plans. [ii]

One option for controlling the risk of geopolitics is to avoid or eliminate them altogether from the portfolio. This can come at great cost however as often perceived elimination of one risk exposes the investor to another. For instance, an investor who invests all their savings in short term treasury bills (T-bills) to avoid market volatility may run the risk of running out of money in their retirement as T-bills have generally not kept pace with inflation over time. Instead, investors may be better served to adapt their investment process to allow for whether something ought to be done or if the best course of action is the status quo. In a recent interview, Brent Joyce, Chief Investment Strategist and Managing Director for BMO Private Investment Counsel, stated; Including geopolitics into an investment process requires the investor to distinguish between short run and long-term risks. Short term risks tend to be acute. They generally go away as fast as they come about, so the best advice is to set-up one’s investment portfolio with an appropriate time horizon. Swift, violent short-term moves in capital markets can come at any time for many reasons, geopolitics being but one. The luxury of choosing to be patient comes with managing a portfolio’s liquidity against the time horizon of various objectives. In plain English, if a certain amount of money needs to be readily available, have that in safe cash-like investments. In parallel with liquidity management, is the power of diversification to ride out short-term risk. In my experience, the cost of knee-jerk reactions often outweighs any gains. [iii]

There are times when changes are more far reaching and represent a sea change. In these circumstances Brent had the following advice: long term risks tend to be chronic and should be addressed. Examples such as the trade dispute between the US and China which emerged under President Trump that have entrenched themselves on multiple sides, or the severing of Russia from the global economy come to mind. These multi-year (perhaps decade) tectonic shifts in the global macro-economic backdrop do provide an opportunity to adjust portfolio strategy. It is necessary for investors to contemplate and incorporate these realities into their investment process. For example, investors seeking exposure to Chinese companies need to research and contemplate the motivations and constraints of policy makers inside an outside of China. Similarly, even if the war in Ukraine were to end immediately, Russia will still be a pariah state and the disruption to global energy and commodity markets will still be an issue. Regional conflicts involving energy have generally tended to be idiosyncratic however the conflict in the Ukraine has changed the game. As a result, you now often find climate and energy security in the same paragraph. [iv]

The events of this past year have reaffirmed the notion that confidence in both the standards of governance and the integrity of its institutional framework are a prerequisite to investing in any country. Among the several institutional investment managers we engage to execute emerging, international, and global markets mandates on behalf of our clients there is a common denominator which transcends all their investment processes. The companies in which our clients’ assets are invested are aligned with structural growth in the global economy, strong balance sheets, defendable market advantages and resilient business models that are believed to enable them to survive and prosper in even the most testing economic and market conditions. [v]

Having an investment process that incorporates geopolitical risk is critically important. Good processes require resources and knowhow not readily available to everyone. Trying to do too much can be costly but missing a sea change could prove costlier. Avoiding pitfalls, or profiting from mispricing due to geopolitical events is a science and an art. It is good practice to seek advice when one is unsure of how to proceed. Afterall, success is not avoiding risk, it’s quantifying it. In so doing the successful path becomes clear.

The views and positions presented are those of the author and are not necessarily the opinion of BMO Private Wealth. The data presented is for illustrative purposes only. Actual results may vary. Nothing presented in this article is meant to be considered financial advice. Readers are cautioned on making any financial decisions based on this text. We recommend investors seek advice from an accredited advisor prior to making any financial decisions.

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