Investing During Times of Geopolitical Uncertainty

In periods of geopolitical upheaval, it is imperative to meticulously understand the nuances of the crisis at hand before determining an investment strategy. Attempting to predict specific outcomes is often an exercise in futility, as these situations are not determined by logical behaviour but by the unpredictable actions of individuals and nations. 

Pundits almost always propagate a narrative of doom because it attracts attention, as do sensationalist media companies. This induces a state of heightened anxiety, driving individuals into a cycle of constant engagement with the crisis. Investor will also churn their portfolios much more than normal, hoping to stay one step ahead of the accompanying market volatility.

However, during chaotic market environments impulsive and reactionary investment decisions are seldom wise. Muddying that water and adding complexity is a tactic frequently employed by sales-driven approaches rather than evidence-based capital allocation.

At Cycas, we prioritize data-driven decision-making. A comprehensive review of historical data reveals a consistent pattern: maintaining composure and continuing to invest is often the most prudent course of action. While each geopolitical crisis has its unique characteristics, the overarching principle remains clear—panic rarely pays off.

The urge for a knee-jerk reaction typically stems from an irrational extrapolation of current events into catastrophic scenarios. Consider the example of Russia’s invasion of Ukraine in February 2022. The initial reaction was dominated by fears of a broader conflict, potentially involving other major powers and escalating into a global war. Such dire predictions, fuelled by media and speculation, briefly became the market’s baseline expectation.

These grim outlooks are predicated on the assumption of an exponentially expanding crisis, akin to the chain reaction triggered by the assassination of Archduke Franz Ferdinand, which precipitated World War I. Out of the 100s of geopolitical crises in the 20th century, only twice has such an exponential chain reaction occurred.

When there is a strong incentive to maintain peace and uphold the status quo, it is hard to imagine how the aggressive actions of a single entity (or nation) could cascade into a series of similar actions by other nations. Understanding the incentives and motivations of the people and countries involved can help investors maintain a level-headed approach.

This is the behavioural approach to dealing with markets during a crisis – understand the motivations of nations (and their leaders), separate posturing from reality, and then have reason to believe in a reversion to the steady-state equilibrium of the status quo.

If this behavioural perspective proves insufficient, a foundational macroeconomic framework can offer additional clarity. According to the Solow Model, an economy’s GDP growth is fundamentally a function of its capital stock (K), labor pool (L), and a residual term (z) that encompasses the gains in productivity of combining of K and L.

The first critical question during a geopolitical event is: Has the country’s capital stock been materially affected? For example, during the Russian invasion of Ukraine, Ukraine’s infrastructure—including buildings, factories, and roads—suffered significant damage. In contrast, India’s capital stock remained intact. Airports continued to operate, industrial production persisted, and agricultural activities proceeded without disruption.

An impaired capital stock unequivocally hampers GDP growth and can lead to long-term economic stagnation. However, post-crisis reconstruction often presents substantial opportunities for local enterprises, reminiscent of the economic boom following World War II, driven by extensive government investment in capital formation. Hence, our investment strategy would necessitate divestment if a country’s capital stock were significantly compromised.

The next important consideration is the long-term impact on GDP growth. Has the geopolitical event altered the economic landscape? Persistent inflation, supply chain disruptions, and brain drain are critical factors to evaluate. For instance, the Ukraine crisis led to significant supply chain disruptions and heightened inflationary pressures globally. However, India’s economic structure remained relatively stable, with no substantial long-term disruptions.

If the fundamental political economy remains unchanged and capital markets continue to be investable, strategic investments in sectors poised to benefit from supply chain realignments, elevated energy prices, and inflationary pressures can yield excess returns. In the absence of a significant regional crisis directly affecting India, these scenarios remain largely theoretical.

Further, assessing changes in the political landscape is essential. Has there been a shift from democratic governance to authoritarian rule? Is the economy under increased state control? Are there signs of financial repression? These factors significantly elevate the country risk premium, rendering the market potentially un-investable.

In the absence of these adverse conditions, we advocate for a strategic approach of ‘buying the dip’. This rationale underpinned our recommendation for clients to capitalise on the volatility triggered by the Russia-Ukraine conflict and the unrest in Israel-Palestine.

India has thus far been spared from a direct geopolitical crisis, but it is crucial to acknowledge our delicate geopolitical position, marked by strained relations with both of our neighbours, Pakistan and China. Indian investors must ensure they are adequately compensated for India’s inherent geopolitical risks.

By maintaining a disciplined, data-driven approach and focusing on long-term economic fundamentals, investors can navigate the complexities of geopolitical uncertainty, avoiding the pitfalls of reactive decision-making.