Grappling with Geopolitical Risks by Sharon Fay, AllianceBernstein

Financial markets have faced an increasing array of geopolitical risks this year. In our view, investors should put these events into the right context and focus on how individual companies might be affected when considering their potential impact on equity positions or allocations.

Lately, it seems like there’s been a new crisis on the front pages every day. We’ve seen the Ukraine conflict, the rise of ISIS and a war between Israel and Hamas. The Scottish referendum and US mid-term elections have added political uncertainty from the developed world. And if all that wasn’t enough, the tragic outbreak of Ebola in Western Africa—and fears of contagion—have increased anxiety further.

Equity investors need to consider how unfolding geopolitical events can affect a portfolio but also maintain perspective on the potential outcomes at the individual stock level.

Systemic vs. Non-Systemic Threats

Start by distinguishing between systemic and non-systemic threats. Systemic threats are those that have the potential to inflict widespread disruption on economies and markets, such as the disruption of oil supply from the Middle East to the West. They’re hard to predict and devastating, but thankfully, also less frequent. It might feel like we’re facing a systemic threat to stability today with so many big issues in the news. But in fact, most of these events pose relatively limited risks to economies and markets.

For example, fighting in Iraq and Syria has exacted a harrowing human toll. But the actual impact for most investors is really limited to the oil price—which is also affected by many other factors. The Ukraine crisis is perhaps more significant for markets; we’ve never really had to assess the potential impact of sanctions on a major benchmark country like Russia before. Yet we can mitigate the damage to portfolios by reducing or eliminating country exposure, hedging currency exposure after evaluating the potential cost and making detailed risk assessments about specific companies’ exposure to sanctions.

Another potential systemic threat today is the Ebola epidemic. If it were to get out of control and spread beyond West Africa the impact on both economic activity and market confidence could be large. Fortunately, successful efforts to contain Ebola in Nigeria and the isolated cases in Western Europe suggest that this is a fairly remote tail risk.

Three Orders of Effects

For non-systemic risks, we think about three types of effects: direct macroeconomic impact, indirect macroeconomic impact and idiosyncratic effects. As equity investors, our analysis of geopolitical risks draws on cross-asset perspectives from fixed-income analysts, currency experts and economists, in order to gain a complete view of complex dynamics.

Direct macroeconomic consequences are usually straightforward. These could include the outlook for the price of oil or the impact of a regional conflict on a country’s economic growth prospects. In Europe, the possibility of higher energy prices owing to sanctions on imports from Russia could also have an effect on economic growth and inflation.

Indirect effects are more nuanced. Our analysts might ask what a particular political situation could mean for consumer spending in a given country. Will terrorism or Ebola depress airline travel? And how might the behavior of other investors in response to a situation create problems? Examples include outflows from UK-based funds ahead of the Scottish referendum or outflows from Russia.

But it’s the specific impact on individual companies that really matters for active managers. Sanctions on Russia will affect banks differently than oil companies or food manufacturers. Oil price fluctuations could cause turbulence for airlines, but the impact will vary depending on how a carrier has hedged its exposure to the oil price. In the UK, investors are concerned about the potential outcome of next May’s general election. One reason is Labour’s promise to cut domestic fuel bills if elected. Yet different utility companies have widely different exposures to such actions.

What Can Investors Do?

With these points in mind, investors can be more prepared. First, think about whether the market’s reaction to a geopolitical situation is proportionate to the actual risk. Sometimes, a spike in volatility might imply that a flare-up is systemic—when it really isn’t. This should give you the conviction and comfort to stick with broader asset allocations or specific positions through bouts of market stress.

Second, for non-systemic risks, make sure your manager is incorporating a meaningful evaluation of the different potential effects on portfolios and positions, including country exposures, individual stocks and currency. In some cases, acute risks detected in a macroeconomic analysis might warrant selling a stock more quickly than usual. In other cases, it may mean standing firm when others are fleeing—or even buying into a controversy when the market reaction appears exaggerated.

Third, investors should make sure that geopolitical outcomes aren’t likely to be a primary driver of returns. Today, that could mean paying closer attention to the country composition of an emerging-market allocation or the sensitivity of a portfolio to oil prices.

Geopolitical risks should never be ignored. But we also believe that they generally shouldn’t be placed at the center of stock-picking decisions. When the going gets tough, make sure the right questions are being asked about your portfolio.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Sharon Fay is Head of Equities at AllianceBernstein Holding LP (NYSE:AB).

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