Managing Investment Risk During Geopolitical Shocks

The human and social impact of any conflict, such as the one unfolding across the Gulf, is paramount and cannot be overstated.

Notwithstanding this, from an investment risk management perspective, markets often deal with uncertainty worse than even materially negative outcomes. Typically, the fear of impending crisis depresses asset prices in the lead-up. Once the event begins, the uncertainty resolves into a quantifiable risk, and the market tends to re-rate higher.

Considering our focus on helping protect portfolios for clients around the world, we analysed 37 major geopolitical events dating back to the start of World War II. The results may call into question the instinct to switch to cash.

The median response of the S&P 500 following a geopolitical shock is, perhaps surprisingly, positive. Indeed, one month after ‘event ground zero’, the median price return is +2.0%, nearly double the unconditional monthly move of +1.1%. It is in positive territory 62% of the time.

On a three-month horizon, the pattern holds: the median return is +3.6% (versus an unconditional +2.6%), also with a 62% hit rate.

However, an overreliance on the median can be unwise. As the chart shows, there are three distinct historical clusters where this rule has failed, leading to deep, sustained drawdowns.

Figure 1. Market returns after a major geopolitical event

Source: Bloomberg, Deutsche Bank, Claude (cross-referenced. Past performance is not indicative of future results.

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The three exceptions

1. The ‘dual shock’ (e.g., 9/11): The 2001 attacks (purple line) coincided with the second leg of the dot-com crash. The geopolitical shock exacerbated an existing economic weakness
2. The existential threat (e.g., 1940): The German invasion of France (navy blue line) represented a fundamental threat to the global order. It was 'properly existential.' This is the scenario where the market structure itself breaks down
3. The energy shock (e.g., 1973): This is the most relevant parallel. The 1973 Arab-Israeli War and subsequent oil embargo (aqua-blue line) caused a persistent, structural impact on energy costs that strangled global growth

What happens if the shock persists?

If we do enter a prolonged period of high tension (such as the 1973-style scenario), what might help shelter a portfolio?

Our colleagues at AHL analysed returns in high-risk environments (defined by the top quintile of the Geopolitical Risk Index [GPR]) which highlights that high levels of geopolitical risk are historically challenging for both equities and bonds.

While returns remain positive on average, they are well below normal levels. Crucially, the ‘flight to quality’ often fails to materialise in government bonds, likely due to the inflationary impact of war or increased government borrowing to fund defence.

This is not just a historical observation; with the current conflict threatening to stoke a fresh wave of global inflation via energy costs, the defensive utility of fixed income is once again under pressure.

Figure 2. Gold and oil have historically been reliable assets during times of stress

Annualised return (%) by GPR quintile (1985+, three-month rolling)

Source: Man AHL calculations. Past performance is not indicative of future results.

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The commodities hedge

Instead, the data points unequivocally to commodities as the reliable ballast.

• Gold has historically behaved exactly as a ‘safe haven’ should. Its returns increase monotonically with the level of geopolitical risk. When the GPR is in the top quintile (Q5), gold returns 12.5% on average
• Oil has demonstrated ‘u-shaped’ behaviour. Its value increases when geopolitical risk is either very low (driven by growth demand) or very high (as a result of supply shocks). In the top risk quintile, oil returns 24.0% on average

Parting thoughts

If, as we all hope, the current situation is contained to the short term, history suggests equity markets will likely remain resilient. The biggest risk to markets lies in the energy shock scenario.

In a more sustained high-risk environment, past episodes have typically seen muted equity returns, while bonds have often struggled to act as a reliable diversifier. In these high-tension regimes, it was real assets, specifically energy and gold, that provided the most consistent hedge.

All data Bloomberg, unless otherwise stated.

Authors: With contributions from our colleagues at Solutions and Man AHL.