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The Impact Of Political Uncertainty On Investments

6th June 2014 Alex Scott, Seven Investment Management

What impact could crises in Ukraine and Thailand really have on investors? 

It’s easy for investors to panic over geopolitics – to sell stocks on every headline about Middle East tensions, to jump into cash at the first rattle of the sabres in North Korea. The issue is relevant now, with some investors worried about a resurgence of violence in Ukraine and another military coup in Thailand.  Unfortunately, selling may well be the wrong reaction.  

On the face of it, investors are justified in worrying. Research by New Zealand academics Berkmann and Jacobsen, published in 2005, looked at the impact of 440 political crises from 1918 to 2002: that’s one starting every couple of months somewhere in the world, with 2 or 3 crises in progress most of the time, and almost no periods with no crisis unfolding somewhere on the globe! Could investors realistically dash for the exits on every brewing crisis? When would they ever re-emerge from safety and reinvest in equities and other risk assets?  

Berkmann and Jacobsen conclude that there is some effect from crises on the stock markets of countries directly involved (particularly in the early stages and especially in more violent crises) but much less effect on countries not directly involved. For an investor looking to apply this finding in practise, there would be huge problems: how to judge in real time when a crisis has started? Surely once it hits the headlines, it’s too late and markets have moved? Perhaps the most useful insight is the notion that a state of crisis is the norm, but yet the world – and less importantly, of course – financial markets carry on in spite of it all. 

What impact could today’s crises in Ukraine and Thailand really have on investors? Ukraine is a 'Frontier' market – not even a member of emerging market indices, so unlikely to feature in most investors’ portfolios; it is a tiny economy on the world stage and not a significant market for UK companies. If the crisis remains domestic, its wider financial impact is likely to be limited. Russian assets may feature in investors’ portfolios – Russia is about 5% of emerging market equity indices and more of EM bond indices: they sold off sharply in the very early days of the crisis but have started to recover as the situation has de-escalated.

Investors are concerned about the possibility of gas supplies to Germany being cut by disruption in Ukraine – a risk to monitor, but one that (like so many other geo-political fears) may never come to pass. As for Thailand, the direct impact seems likely to be limited: Thailand features in the supply chain of some technology products, so prolonged serious disruption could have a broader impact, but the crisis appears not to have reached that level. Most investors will have little or no direct exposure, with Thailand accounting for just 2% of global EM equities and not much more of EM bond indices.

Those companies that operate in emerging and frontier markets have learnt how to do business there. Standards of corporate governance may differ, just as legal systems, tax codes and cultural expectations may differ, but companies and investors have learnt to cope or even thrive. Changes of government may happen in more unconventional ways than we are used to in Europe, and political disagreements within or between states can tip into violence more often. The human tragedies are real, by the time we read about them, it is often too late to act.

Crises are not easy to predict: over the past few years, investors have worried about war between Pakistan and India, conflict in Korea, regime collapse in Saudi Arabia, unrest in Nigeria hitting oil supplies, the possibility of Israeli airstrikes in Iran – and many more “false alarms”. The investor who rushed for cash expecting the worst on such fears would have missed very strong equity market returns. And remarkably few predicted Russia’s actions in Crimea, even once the Ukraine crisis was underway.

We all know Baron Rothschild’s famous recommendation in 1810, “Buy to the sound of the cannons, sell to the sound of the trumpets” – the suggestion that investor panic about outbreaks of war and crisis can lead to opportunities for the brave investor to buy undervalued assets from the panicky sellers. There is probably still wisdom in this.

About the author - Alex Scott is the Deputy Chief Investment Officer at Seven Investment Management


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