As the world faces a new Cold War and Russia is hit with severe sanctions, investors, IFAs, executives, and economists around the globe are preparing for the onslaught of effects this will have on the volatility of markets, commodity prices, and currencies.
Investors are already weighing up how sanctions will impact them long-term, with many flocking to bonds as a safe haven. But how can geopolitical risk be quantified in times like these? After all, military conflict, terrorist threats, and war are the major drivers of instability in the equity markets, making it very difficult for investors to react to such uncertainties.
The Geopolitical Risk Index (GPR) by Caldara and Iacoviello has found correlations between higher levels of geopolitical risk and capital flow increases to developed markets and lower flows to emerging markets. Their studies established that higher increases in the index result in lower stock returns and inverted yield spreads, which severely weakens economic activity and affects everything from trade to employment to industrial production up to a year after the initial spike.
As these risks create so much uncertainty, decision-makers are essentially forced to hold back from committing to any major investments. This translates into financial firms pausing recruitments and investment decisions, consumers holding off from making big purchases like houses or cars, and investors idling on their plans as they try to gauge the economic repercussions on the global markets.
The GPR analysis also concluded that financial markets and economic activity are more affected by the threat of geopolitical risks than by actual events (as we are now seeing with Russia’s corporate exodus and nuclear threats). Threats alone spur an increase in downside risks and uncertainty, whereas actual events have a tendency to resolve uncertainty and elicit social, economic and protective policy responses. This finding reinforces the old “buy the rumour, sell the fact” stock phrase.
Investing in FX in Times of Geopolitical Instability
As discussed, tensions over geopolitics can lead to lower stock prices and ramp up returns for what investors believe to be safe haven assets like government bonds and liquid FX currencies. Even though staying invested in riskier assets could be better for investors, in the long run, ignoring geopolitical risks could have consequences on their portfolios when the GPR index is elevated.
Financial advisors can look out for their clients by educating them on safe haven assets like FX, which could help structure their trading and investment efforts during times of uncertainty. Some good reasons why clients of IFAs should look to Forex Trading are:
As is the case with stocks, bonds, real estate and commodities, currencies have capital appreciation. This means that investors will profit if the dollar drops against the values of their chosen currencies. If currencies fall relative to the dollar, naturally, investors will lose money. The good news is that such fluctuations are likely to balance out in the long run, and investors can still benefit from the diversification of spreading their investments across various markets.
Level Playing Field
Unlike the stock market, investors can always access real-time information that drives currency prices. As all currency valuations are based on the actual flow of money and the events that impact economies, investors can analyse these findings to determine how currencies are affected, mitigating the need to rely on outside sources.
Particularly if US equities are already a focus point, investors can use currencies to balance their portfolios. When one currency is up, another will always be falling; therefore, clients can purchase more currencies they think will rise if they believe the dollar will drop in the future.
There are escalating fears that the US fiscal and current monetary policies will see the dollar weaken and increase inflation over time. Interest rates are at an all-time low, and with budget deficits growing, there is a legitimate cause for concern. However, currency traders are closely tracking these developments, and the FX market allows traders to select the currencies they believe will change over time based on their relative values.
Investors have the freedom to bet both ways depending on which direction they believe a certain currency is likely to go. Risks can be allocated across numerous currencies for several countries, which allows investors to profit from global macroeconomic conditions that are known to fluctuate.
Hedge Against Political Risk and Global Events
Based on a strategic assessment of the events occurring around the world, investors can easily play currencies against each other, even in times of geopolitical uncertainty. Whether there are changes to interest rates, taxes, world leadership, monetary policy changes, restrictions on imports, or currency values, there is still room for manoeuvrability when it comes to active asset allocation.
The same applies to significant global events of an extreme binary nature like wars, nuclear threats, trading sanctions, recessions, climate crises, trade deficits, and pandemics – the markets can witness these events with varying magnitudes, which can help ease tensions when it comes to making informed investment decisions.