Geopolitics: conflict, elections, and investment markets

Major geopolitical events are rarely out of the headlines, but as Matt Tickle examines, are they really driving movement in investment markets?

Geopolitical concerns have arguably been at an elevated level for much of the past decade; however, these truly came into focus with the economic and financial disruption following the Russian invasion of Ukraine. These concerns have spread with the expanding conflict in the Middle East over the past nine months.

_{Source: Caldara, Dario and Matteo Iacoviello (2022), “Measuring Geopolitical Risk”}

However, while the humanitarian impact is always terrible from any conflict, the impact from a global economic perspective of recent conflicts has been relatively limited. 

Another source of uncertainty are elections. These can dominate headlines with coverage of often small changes in opinion polls and campaign promises that are not always enacted.   

In contrast, seemingly small and lightly reported policy changes or rising geopolitical tensions between major economies can have a substantial economic impact. 

In this blog we explore how investors can make better decisions by taking a step back from those geopolitical developments that will dominate headlines, but that are unlikely to reward the time spent following them, and instead focusing time and energy on those developments that could have the largest impact on your portfolio.

Conflict in the Middle East 

Conflict in the Middle East tends to generate a huge amount of attention and press coverage, with a focus on the humanitarian tragedy and the extreme downside risks of a major escalation. However, in the most likely scenarios the economic and market impact is likely to be more limited. 

Energy markets

Memories remain of the impact on global energy markets, and the knock-on inflationary impact, from previous conflicts in the Middle East and from the recent Russia/Ukraine invasion. However, there are reasons to be less fearful:

• The world is far less dependent on oil overall than it used to be. The amount of oil required per unit of global GDP is less than half of that required in the 1970’s.
• The US is the world’s largest oil producer for the first time since the early 1970’s. Therefore, the world is far less dependent on Middle Eastern oil than it was in the 2000’s at the low point of US production.
• Despite heavy sanctions since 2022, Russian production has barely fallen, although the ultimate destination of the oil has changed.
• While Iran remains a significant oil producer, its share of global markets is low, partly because of existing sanctions. It already sells very little oil to western markets, with the majority sold directly to China, so exports are unlikely to be significantly disrupted by further sanctions.

_{Source: Refinitiv, International Energy Agency}

There is a risk to this view however, stemming from the disruption of maritime trade, particularly through the Strait of Hormuz. The Iranian-backed Houthis have shown their ability to disrupt shipping elsewhere, in the Red Sea, which has raised shipping prices, albeit with prices remaining far below the post-pandemic high points of 2021 and 2022.

However, fully blocking this chokepoint would likely dramatically escalate the conflict, potentially bringing Saudi Arabia and the other Gulf states into direct confrontation with Iran. Because this would be such a huge escalation, markets consider it unlikely and have done little to price in this outcome. Instead energy markets have continued to move more in line with changes in macroeconomic factors such as global growth.

Investors’ exposure to the region

Because of stock market capitalisation, the direct exposure of most investors to the region is usually small, and smaller than the direct exposure to Russia (now sanctioned) and Ukraine. Israel is the region’s largest equity market, but makes up only 0.25% of global equities, and Iran has been under heavy western sanctions for many years and investors are likely to have no direct exposure whatsoever.

2024: the year of elections

In 2024, countries representing 40% of the world’s population and GDP will take part in national elections, heavily influencing global policy and geopolitics over the next four years. 

_{Source: World Bank, Barnett Waddingham}

However, even in the largest countries, investors may not need to spend too much time considering the outcome. The elections may not be free or fair and so unlikely to lead to change (notably the recent election in Russia) or the current government may be highly likely to retain power. In Mexico and India, the current government parties have huge leads in the opinion polls and in Indonesia, the winning candidate was backed by the popular outgoing President.
 
With those caveats, the elections investors most need to pay attention to are the UK general election and US presidential election. In the UK, Labour looks likely to return to power for the first time in 14 years and in the US the race remains too close to call. We will have more to say on the specific points of both elections later in the year.
 
Even where governments change, they are usually more constrained than they appear. Lack of control of all parts of government (like the US House and Senate), small majorities, and internal party splits can all delay or prevent policy changes. Even policies that don’t require legislative change are often restricted by the courts, bureaucracies, independent bodies, and international obligations. Markets tend not to like disruptive change and so often perform well when governments are restricted by these factors.

Instead of focusing on elections, we feel investors should spend more time thinking about individual policies as they are implemented and try to look ahead at the wider implications of those policies as they come into force.

What Geopolitical factors have been driving markets?

Whilst we have cautioned against over-reacting to election news, or the market impact of conflicts, there are nevertheless several less headline grabbing geopolitical factors clearly impacting markets.

Trade Policy

Arguably the most significant policy change of the 21st century is the United States–China Relations Act of 2000, which allowed China to enter the World Trade Organisation. Since then, China has risen from 3.6% of global GDP to 17.8% in 2022. This is an important example of a small change in policy that contributed to an economic impact bigger than most armed conflicts.
 
However, in recent years US-China relations have deteriorated and their openness to trade has reduced. This first generated headlines in 2018 as Donald Trump applied tariffs to Chinese goods including steel, solar panels and washing machines, but restrictions have only increased under Joe Biden. Most of Trump’s tariff measures have been maintained, but more focus is now placed on high-tech industries, including blacklisting Huawei from US telecoms, restricting exports of high-tech computing chips to China, and forcing the Chinese owners of TikTok to sell the American arm of the company by 2025. This is only a small number of the more high-profile US measures, with China applying its own restrictions in response.

These measures are all part of a global “re-shoring” trend. Countries are looking to bring production back under domestic or allied control, particularly for “strategically important” industries. This has contributed to a stagnation in global trade in recent years. If tensions continue to rise, particularly with China which is the world’s largest exporter, then this trend is likely to continue with potential - albeit contained - implications for global growth and inflation and monetary policy, and on corporate revenues and profits.

_{Source: Barnett Waddingham, World Bank; Federico & Tena, 2018, "Federico-Tena World Trade Historical Database : Openness"}

Defence spending

As geopolitical tensions have increased another notable change in policy has been an increase in defence spending across the world. For example, Rishi Sunak has pledged to increase defence spending to 2.5% of GDP by 2030. In a historical context this would still leave UK defence spending at a relatively low level.

_{Source: World Bank}

However, because defence spending has been so low, even a relatively small increase translates into a substantial increase in revenue which is shared between a handful of large aerospace and defence companies. Since the Russian invasion of Ukraine, the FTSE World Aerospace and Defence sector has outperformed the FTSE World Index by 24%. 

For investors with exclusions from defence industries this is likely to harm returns relative to the overall index; albeit the impact is likely to be modest as the sector makes up only 1.9% of the FTSE World equity index.  So even this political act is unlikely to materially drive overall portfolio level returns.

Conclusion

We are in an era of elevated geopolitical risk that is changing the nature of globalisation and leaving many investors feeling cautious. Whilst some caution may be warranted, and portfolios should certainly be alive to the changing shape of globalisation, we encourage investors not to sit fearfully on the sidelines due to the predominance of headlines on these topics. Doing so may well mean material lost opportunities as the headlines, tragic and worrying though they may be, far outweigh the actual economic and market effects.

This article features contributions from Callum Smith, Senior Research Analyst.