To exit or not to exit – how to manage geopolitical risk

Markets remain concerned about the potential for further escalation of the conflicts in Lebanon and Ukraine with no clear end. Picture: AFP

Geopolitical risks are elevated. Israel launched a ground offensive in Lebanon for the first time in almost two decades and the conflict has the potential to deteriorate further.

At the same time, the war between Russia and Ukraine continues. But while the threat of a further escalation has increased, we currently don’t see the benefit in exiting risk assets, given strong economic and earnings fundamentals.

Instead, we favour strategies to manage potential volatility, as we maintain our view that risk assets have further room to run.

Markets remain concerned about the potential for further escalation of the conflicts with no clear end.

Brent crude, seen as a proxy for risk in the Middle East, has pulled back given recent news reports that Israel will strike Iranian military, not nuclear or oil, targets and sits around $US75/bbl. Gold is also trading near its all-time high.

But while investor sentiment is still fragile amid escalating tensions in the Middle East, we wouldn’t consider exiting risk assets, as we continue to see an overall supportive backdrop for equities.

In fact, in recent days, the UBS Chief Investment Office points to a “no landing” scenario for the US, in which inflation is close to the Fed’s target but GDP growth remains at or above trend estimates while household balance sheets remain strong. With all those events factored together, we upgrade US and global equities to attractive from neutral.

The market impacts from war and geopolitical crises have historically been temporary. Over the past year, the S&P 500 has risen by over 30 per cent.

Data over the past eight decades also shows that the effects of international conflicts on financial markets tend to be short-lived.

Since 1941, the S&P 500 has been higher two-thirds of the time in the 12 months after the start of a geopolitical crisis; half of the time, it has only taken markets a month to recover. Selling in response to immediate uncertainty locks in otherwise temporary losses and hampers investors’ ability to ­participate in the next market ­recovery.

Recent data underscores a resilient, albeit slowing, US economy. Stronger-than-expected labour data alleviated US recession fears, as the economy in September generated the most jobs since January, with higher hourly earnings growth and a lower unemployment rate.

Trend measures of inflation show inflation slowing to the lowest level since 2021 and household balance sheet are strong. We expect the Federal Reserve to reduce interest rates by another 50 basis points by the end of this year, supporting the economy, with a further 100bps of cuts in 2025.

Turning to the US election, the outcome remains too hard to forecast as the competition tightens and campaign rhetoric heats up. While US Vice President Kamala Harris has maintained a narrow but consistent polling lead over former President Donald Trump, we anticipate uncertainty and volatility to rise until the next US administration is settled. Predicting final policy outcomes is tricky as candidates can abandon campaign pledges, and Senate and House composition matters.

Historically, it has not been uncommon for the US election to shift in the final months of the campaign. Candidates with an early advantage failed to take the White House in 1980, 1988, and 1992.

In the current environment, US political outcomes are far from the largest driver of financial market returns.

The election is taking place against a backdrop of Fed rate cuts, US economic momentum, and supportive secular trends like generative artificial intelligence.

A well-constructed portfolio management plan should be able to withstand the market volatility surrounding a close election, and we think that reducing equity exposure in the wake of a “disappointing” election outcome is likely to be counter-productive over the longer term.

Both parties are concerned about the security and economic risks posed by trade with China.

So while the manner of intervention may vary depending on the election result, a trend towards protectionism is likely to continue regardless of who wins. Investors should therefore assume greater obstacles to free trade over the medium term.

This could accelerate investment trends like nearshoring. Sectors that benefit from nearshoring include infrastructure and robotics, as companies build up production facilities in alternative locations.

Third-quarter earnings should highlight healthy corporate fundamentals. Major US banks and several prominent consumer names have started the third-quarter reporting season, and we continue to expect S&P 500 earnings per share to grow 11 per cent this year.

The structural growth story of AI also remains supportive, with demand continuing to exceed supply for AI infrastructure. We believe now is the time for investors lacking AI exposure to plan for periods of volatility in the tech sector to build up long-term positions. Overall, we expect the S&P 500 to rise to 6300 by June 2025. Additionally, we are also keeping an eye on more forceful policy interventions in China, which has prompted us to take a positive view on Asia ex-Japan equities. So while further volatility is possible in the near term, investors should stay the course and consider measures to manage market swings given the fundamental backdrop remains constructive.

During this volatility, companies remain committed to their AI investment plans so we continue to position for AI beneficiaries, including megacaps, as well as a broad suite of quality growth stocks in the healthcare and consumer sectors. As for improving the resilience of portfolios, investors can consider an allocation to hedge funds and structured strategies, and an exposure to gold, oil and the Swiss franc.

Diversification has also been shown to help reduce portfolio volatility, ensure investors tap more sources of return, and help investors avoid behavioural bias amid uncertainty.

However, with all decisions, investors should seek out the appropriate advice, as the best choices for your portfolio will depend on your circumstances.

Stephen Cabot is an investment consultant at UBS Global Wealth Management.