Fear itself

It's telling that the US's decision to defer tariff increases that were scheduled to escalate on March 1 now qualifies as "good news" on the geopolitical front...

After all, with the North Korean negotiations having hit an impasse, the UK facing yet another deadline for reaching agreement on the terms of BREXIT and Robert Mueller said to be finalizing his investigation of the Trump Administration, there is no shortage of issues for market participants to worry about. Against this unsettled geopolitical backdrop it's been easy for investors to lose focus and get distracted.

But should any of these issues really alter the way that we position investment portfolios?

Just this past week we celebrated the 10-year anniversary of what has now become the longest running bull market in history. We've also now transitioned from mid-cycle to late-cycle in the current economic expansion. These sorts of milestones understandably raise concerns about both the durability of the expansion and sustainability of the bull market. Since this week's Deeper Dive goes into some detail over how policy makers are responding to signs of softening growth and more volatile market conditions, I'll turn my attention to the impact that geopolitical developments could have upon both the real economy and financial markets.

First, it's important to understand that there are always developments on the world stage that will garner headlines and potentially unnerve market participants. Looking back over the past decade there have been periodic flaring of tensions in the Middle East, repeated crisis in the Eurozone, terror attacks against western targets and large scale natural disasters across the globe. Each contributed to periodic surges in volatility, yet none were able to ultimately derailed the bull market.

So what about the current environment?

With the expansion now showing some signs of aging, the options available to policy makers more limited, and most risk assets trading at fuller valuations, it would appear that there is greater vulnerability to the sorts of “event risks” currently festering on the geopolitical front. Among the most important are the prospects for a full blown trade war between the US and China, the possibility of a major misstep by central bankers as they seek to normalize policy and the threat of a hard BREXIT should the UK and EU fail to come to terms on a workable compromise that Parliament will approve.

While each of these could well trigger both a recession and bear market, we must first determine if any have yet reached what we consider to be a “macro-impactful threshold.” We ascertain this by assessing the following four criteria: (1) is the event global in scope; (2) would it have a material impact upon markets; (3) is it a high probability event; (4) is it urgent or imminent from a timing perspective? Although each of the risks that we monitor score high on at least one of these measures, none have reached the critical level on three or more.

For example, while a central bank mistake would be both global in scope and have a significant market impact, we don’t consider this either an imminent threat or a high probability event. Likewise, our “base case” scenario for the US-China trade dispute calls for continued tensions between the two parties, but no escalation to a full blown trade war. Lastly, while the probability of a “hard BREXIT“ has risen in recent months, this poses more of a threat to the UK than to the global economy.

Bottom line, there will always be events on the geopolitical scene with the potential to trigger episodic bouts of volatility that unnerve market participants. But the key to managing through these risks lies in determining which have reached the macro-impactful threshold and which are fears that need to continue to be monitored but don't merit a shift in the investment stance.

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