Originally published in HANetf’s Thematic & Digital Assets Review
Constructing a robust portfolio typically means balancing diversification, asset allocation, and risk management. But as we navigate through an era marked by renewed geopolitical uncertainty, investors may need to start factoring in another risk in their portfolio construction: geopolitical risk. Major geopolitical shocks tend to lead to drops in equity indices. By holding certain assets that have the prospect to see price rises during a geopolitical shock, investors can potentially limit their losses.
In this article we will outline why geopolitical shocks may become more common and three assets that may serve as a hedge in such events: defence stocks, gold and bitcoin.
Why investors may now face greater geopolitical shocks
While all investors will have previously considered geopolitical risk, the need was less urgent in recent decades.
As academic studies have shown, the end of the Cold War marked a more benign geopolitical environment, with both inter- and intra-state conflict declining.
But this benign geopolitical environment, many fear, may now be coming to a close. With the global order potentially in flux, there is a sense that the world is now beset by growing tensions between major powers and, with it, greater risk of geopolitical shocks.
As Lizz Ann Sonders of Charles Schwab notes: “There is no question we are seeing profound geopolitical shifts internationally, with the re-emergence of big geostrategic power rivalries (e.g., China vs. the United States and NATO vs. Russia).” Since such risks are potentially global in nature, they may be difficult to diversify away from.
Defence stocks and the “flight-to-arms”
Defence sector firms typically see price rises following a geopolitical shock. This is usually based on markets anticipating that the outcome of a geopolitical shock is an increase in military spending from governments, either to pursue military action or strengthen national defence.
This trend was uncovered by the work of several academics in the International Review of Financial Analysis, with a paper titled ‘Geopolitical risk and the returns and volatility of global defence companies.’
The paper looked at the returns of 36 defence companies and their correlation with the Geopolitical Risk (GPR) Index of Caldara and Iacoviello.
The researchers noted that while returns of defence companies were rather detached from GPR before the Russian invasion of Ukraine, they became heavily correlated in the period from February to early April 2022 as conflict broke out. The research shows that this was especially true for US and European defence stocks. The paper notes: “A shared conviction that these companies will capitalise on higher defence spending amid the war in Ukraine provoked the investment actions of longer-term investors which resulted in positive return.”
This phenomenon is termed by the academics as a “flight-to-arms”, which, they argue, has parallels with the well-known flight-to-quality phenomenon whereby investors move from risky assets to less risky and safe-haven assets.
As a result, the researchers argue that the findings may be of use to portfolio and risk managers to optimise investment and hedging strategies. Put simply, by gaining exposure to defence sector stocks, investors can hedge against geopolitical risk. In the event of a geopolitical shock, such as Russia’s invasion of Ukraine, exposure to defence sector stocks can potentially offset losses while other asset prices are under pressure.
Gold: a new reason to hold a traditional safe haven
The price of gold often rallies during times of geopolitical uncertainty. As a result, many investors hold gold as a hedge. It is often seen as the ultimate safe-haven asset.
Gold has been used as a store of value since the start of recorded history. Companies can go bankrupt, governments can default, currencies can devaluate, and countries can go to war – but gold endures. The metal has shown very strong resilience in its value over time and is universally accepted.
Therefore, gold shows a strong correlation with geopolitical risk. As Mark Rosenberg, founder and CEO of GeoQuant notes, gold has a strong correlation with the GeoQuant Global Political Risk Index, sitting at around 0.72.
Correlations (day-on-day): 1 Jan 2017-7 Dec 2020
But the current geopolitical environment adds another element to hedging with gold. Following Russia’s invasion of Ukraine, the US responded with robust sanctions, leveraging the central role of the US dollar to the global financial system. Some have accused the US of “weaponising” the US dollar.
This, some argue, risks chipping away the US dollar global reserve status, as countries decide to diversify away from the dollar. Economic historian Barry Eichengreen has warned that the more the US uses the dollar to pursue its geopolitical interests, “the stronger the incentive for governments to invest in alternatives, and the faster the movement will be.”
As a result, following sanctions on Russia in 2022, there has been growing talk of de-dollarisation. This has been spearheaded by Russia and China, alongside some members of BRICS Group.
While the prospect of another currency replacing the global dominance of the US dollar looks unlikely, it is an added risk to consider in the face of geopolitical shocks and a world of increased international tensions. Gold, therefore, offers a potential hedge against this.
Indeed, in the absence of any other contender for reserve currency status, countries diversifying away from the dollar have opted for gold. Accordingly, 2022 saw global central banks buying up record amounts of gold.
Potential geopolitical shocks, therefore, may further add to this sense of de-dollarisation, particularly if such shocks come in the form of growing US-China tensions. Such tensions are likely to add to Chinese efforts to dethrone the dollar as the global reserve currency. This will potentially be constructive for gold prices, adding to its appeal as a hedge.
Bitcoin: the new gold?
Bitcoin is a relatively new asset class. Correlations between bitcoin and geopolitical shocks are not yet well established. Its price has often swung widely owing to retail-driven speculation and the internal dynamics of cryptocurrency.
But that is not to say it couldn’t potentially serve as a hedge against geopolitical risks once the market matures. Bitcoin’s appeal as an asset class is often associated with scepticism over the longevity of the US dollar. Therefore, it is not inconceivable that in light of geopolitical shocks that raise prospects of de-dollarisation, there will be upward pressure of bitcoin prices. The cryptocurrency could gain a similar appeal as gold in this regard.
At the same time, Bitcoin’s correlation with equities is very low. Over the past three years, the correlation between Bitcoin and the Nasdaq 100 has been around 0.4. If hedging against geopolitical risk is about diversification away from asset classes that are directly impacted, Bitcoin could potentially fulfil that role.
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