The Potential Impacts Of Geopolitical Risks On Financial Markets

Includes: DIA, OIL, SPY, USO
by: Manning & Napier

As a global investment management firm, it is critically important that we monitor any and all varieties of risk that could threaten the performance of financial markets both domestically and abroad. Today, developments in a number of regions, particularly the Middle East and Eastern Europe, have brought geopolitical risk to the forefront of our minds. Below we describe some of the issues, why risks are rising, and how they may impact financial markets.

There can be no doubting the fact that the Middle East has, in some way or another, been something of a powder keg for the better part of the last 50 years. This dynamic has conditioned investors to accept that conflict is simply par for the course, and uncertainty is the unfortunate cost of doing business in that part of the world. Yet recent events have unfolded such that increased prudence is warranted.

  • In Iraq, a violent struggle between the predominantly Shia government and a Sunni militant group known as the Islamic State of Iraq and Syria (ISIS) is threatening the stability and governance of the nation. The fighting has the potential to disrupt the country's oil production and exports, which in turn would impact global energy prices. ISIS has already captured a number of cities in northern Iraq and has launched attacks on several of the nation's oil refineries. While a majority of the production and refining assets that process oil for export operate in the southern part of Iraq where they are protected by Shia strongholds, the potential for disruption certainly exists.
  • The intensification of armed combat between Israel and Hamas in the Gaza Strip provides more cause for concern, as well. Though its potential impact on oil prices is likely minimal, the conflict could drive up risk premiums in global equity markets and decrease investors' appetite for riskier assets.
  • The recent deal between Iran and the Western powers appears not to be yielding sufficient progress. Earlier in the year, an agreement was reached that called for curbs on Iran's nuclear program over a six-month period. Though Iran has long claimed that it seeks to refine uranium only for use in civilian power plants, Western powers and their allies fear that Tehran is seeking to develop nuclear weapons. A four-month extension narrowly averted a situation that could have further escalated tensions, but serious gaps in negotiations still exist regarding the long-term future of the Iranian nuclear program.

Geopolitical risk is not simply confined to the Middle East. In Eastern Europe, the downing of a civilian jetliner in July was a tragic reminder that the struggle for autonomy in eastern Ukraine is far from resolved. The divergence up until now between the U.S. and its European allies regarding their willingness to employ punitive measures against Russia for its tacit support of pro-Russian separatists has dampened the effectiveness of sanctions, which have yet to force Russia to rein in its interference in eastern Ukraine. It is possible that new developments could tip the scales in favor of a swifter resolution. Russian President Vladimir Putin is sure to come under heavy scrutiny as more details of the jetliner incident emerge. However, initial indications are that Putin's administration remains defiant of Ukrainian and Western positions on the issue. This could lead to a further escalation of painful economic sanctions against Russia, although the fact remains that Europe is highly dependent upon Russian energy, and European policymakers are sure to be wary of tipping their fragile economy back into recession.

Financial markets have largely ignored these risks thus far. While there is a chance that the current period of rising tensions leads to progress in some of these issues and a de-escalation of stresses, investors must be cognizant of the risks that geopolitical tensions now pose.

In our view, the most significant risk from the aforementioned issues would be a spike in global oil prices. An additional consequence could be a rising risk aversion among investors, which would impact equity risk premiums across the board and most likely impact emerging markets most severely.

Should events cause oil prices to rise, we believe investments in the energy sector, and more specifically in oil-service companies, stand to benefit. Many of the portfolios we manage contain meaningful exposure to businesses that benefit from the capital spending decisions of oil producers. As for the additional possibility of rising risk premiums, for some time we have focused on owning leading, globally-competitive, innovative companies that are growing despite today's slow-growth environment. If an eruption of geopolitical stresses was to negatively impact equity prices, we would likely view the spike in volatility as an opportunity to initiate positions or increase exposure to the most promising investment opportunities we see globally.

To sum up, we live in both exciting and dangerous times. The possibility of further escalation in geopolitical tensions is one of the most significant risks we monitor as we invest globally. The situations in the Middle East and Eastern Europe are likely to stay tense, and there is a non-zero chance that more conflict ensues, leading to rising oil prices and heightened risk aversion. This is not our base case today, but we stand ready for such a scenario. Should market volatility increase, we would view it as a potential opportunity.