Investing in model portfolios through geopolitical shocks

Key takeaways

1. Geopolitical events can inspire emotional selling, but prudent portfolio management should be case-dependent.
2. Changes in cross-asset opportunities, and whether they’re tradeable, help determine whether portfolios benefit from rebalancing.
3. The preference of the Target Allocation team is to generally stay the course through big headlines.

Geopolitics and exogenous shocks inevitably make rough ride moments when investing. Developments and the news cycle around them introduce uncertain variables and real emotions that can cause investors to reconsider positioning. New risks can structurally shift outlooks for asset class returns; but obtaining a grounded assessment of the durable impact on fundamentals is anything but easy. Trading around these events, or deciding not to, can be difficult. Most geopolitically important events over the past 50+ years had surprisingly weak impacts on risk asset prices in the US, and the Target Allocation team takes that as a starting point but not as a conclusion when asking if the risk-reward could be shifting and whether cross-asset relationships have meaningfully changed.

At the end of the day, we care about the opportunity set for cross-asset investing (investing across asset classes according to perceived relative strengths). Markets influenced by short-term traders and fast-paced algorithms can have knee-jerk reactions yet may end up circling back to where they started (see chart below).

When the earnings outlook, direction of rates, or incremental reward for risk-taking shift substantially, that’s when our asset class views start to adjust. Startling news doesn’t always meet criteria, especially when dynamic companies and economies adjust more nimbly than expected or are more isolated from harm than feared.

Following the recent energy market disruption, our team revisited historical equity returns after large oil shocks. The results were surprisingly tame. The emotional bias is to immediately divest from equities amidst oil disruptions due to their potentially undesirable impacts on GDP and inflation. It’s generally true that with all else equal, higher oil prices can be an inflationary impulse with contractionary effects on growth. The myriad of factors that coincide with the shock, however, can outweigh higher prices. Energy intensity in the economy, underlying durability of economic growth, and the reaction in rates determine how a shock can trickle into fundamentals like corporate earnings and consumer spending. Front-month WTI futures (West Texas Intermediate crude oil contracts) went up 50% from trough to peak in 1996 but didn’t shake the bull market¹. In the 1970s, however, risk assets sold off because an energy-dependent US was deeply affected by the rise in oil. Assessing the environment as a whole – whether earnings are expected to take a leg down, whether there are alternative scenario-hedging sources of return still available – is critical.

What if markets are moving but the story’s impact on investing is ambiguous?

When the effects of an exogenous shock are largely unclear, we generally choose to hold steady. The investment team looks for market events that are tradeable, with potentially attractive forward effects on asset class returns. Markets pricing in situational ambiguity represents basic volatility, and a key principle to investing for the long run is weathering vicissitudes. In those moments we stay grounded to our signal-set and research for guidance – that’s where we believe our edge lies.

How does the model portfolios team assess recurring events?

We have a breadth of relevant research to serve as a playbook when non-market events are deemed predictable or recurring. Whenever events are incoming, the investment team determines whether the circumstances are tradeable and have clear catalysts. If so, these events can be opportunistic for us. For example, sea changes in investor outlook have occurred around elections, which have allowed Target Allocation models to opportunistically make several election-time trades.

Final thoughts

Generally, our preference is to stay invested. Our bar for adjustment tends to be substantial when geopolitical developments are in play. Overreacting to headlines may cause investors to miss out on big days in the market. These developments certainly have the capability to move the needle, but most times it may simply be better to hold on. Fine-tuning adjustments believed to be additive to results, rather than big swings, are the typical response of the team.