29 November 2017
This article is part of the UBS House View Year Ahead 2018, our yearly outlook on markets. You will find investment ideas and portfolio implications in the full report.
With Russia and China asserting their presence on the global stage, North Korea developing nuclear weapons, political instability rising in the Middle East, the UK negotiating its exit from the EU, mid-term elections coming in the US, and elections taking place in Italy, Brazil, Mexico, Russia, and Malaysia, global politics will continue to reshape the landscape throughout 2018. But to what extent does it matter?
The relevance of geopolitics for investors is debatable. Despite the significant media attention, and the plethora of political events and shocks in the past two years, the best strategy for investors would have been to turn off the 24-hour news and stay invested. Trying to trade the events could have been costly – the FTSE 100, for example, lost nearly 9% in the immediate aftermath of the UK's EU referendum, but it recovered within days and closed the year sharply higher.
In our view, a calm market is not necessarily a complacent one. We believe that the impact of domestic politics on global markets is generally overestimated.
Britain's exit from the EU, Catalan separatism, sanctions on Russia, and modifications to the North American Free Trade Agreement (NAFTA) might have meaningful effects on the UK, Spanish, Russian, and Mexican markets, respectively, but their relative impact on markets internationally is much smaller. Individual political issues can cancel one another out, and since markets focus on long-term cash flows, policies instituted by a government whose mandate will expire tend to get somewhat discounted.
How have financial markets reacted to geopolitical events in the past?
Test your knowledge and compare your findings with what actually happened.
Throughout history, geopolitical events have had a deep impact on our lives. But what is their impact on the financial markets? The answer might surprise you.
1989: Fall of the Berlin Wall
The fall of the Berlin Wall on November 9 1989 marked the effective end of the Cold War, that had dominated the post-war political landscape.
From 1940 to 1943 the Dow steadily declined, hitting its lowest point around July of 1942. But by the end of the war, the Dow bounced back above its pre-war level.
What's the conclusion?
While geopolitical events can have a deep impact on our individual lives, the impact on global financial markets tends to be smaller, and more short-lived.
Investors should diversify globally and stay invested through periods of turbulence.
Scenarios to watch out for
While we don't expect politics to sway global markets in the coming year, it can affect investors in three specific circumstances.
First, in extreme events such as wars. The 1940 Battle of France caused the S&P 500 to decline by 14% in the week of the invasion, while the oil crises of the 1970s and early 1980s, resulting from the Yom Kippur War (and associated embargo), and the Iran-Iraq War respectively, both contributed to global financial market turmoil. Second, in case the global economy suffers a downturn. With interest rates still at low levels, and the marginal returns from quantitative policy diminished, should the next global downturn arrive, fiscal policy could have a larger role to play, compared to the last recession where central banks did most of the heavy lifting. Finally, even relatively minor local political events can affect investors who are too heavily concentrated in individual regions or sectors.
As politics will once again be in a flux in 2018, we expect the global impact to be limited, but investors should pay close attention to risks and opportunities locally.