As we look around the globe today there is no shortage of geo-political tension.  From the conflict between Russia and Ukraine, the seemingly ever-simmering territorial and civil battles in the Middle East to less publicized but no less significant tension between Japan and China, there is no shortage of unrest to be concerned with.   Add to these issues the potential for another bond default by Argentina this week and you have a pretty challenging environment in which to make investments.

I’d like to take a minute to give a brief overview of how we consider these risks in our investment management process.  As we have stated before we combine a top-down macro-level assessment with a research-driven bottom-up perspective to identify new opportunities or uncover risks.

In an attempt to make the assessment of geo-political events visually clear I’ve put together a four-quadrant diagram.  Along the horizontal axis is the potential impact of an event to the underlying health and stability of the global economy.  Uncertainty is not a friend of the financial markets so anything that can lessen confidence or create less favorable outcomes can negatively impact short-term market performance.  The vertical axis represents the probability of the worst case outcome being realized.

There are events that occur which have high potential impact but the probability of the worst case outcome is low so the markets may seem to be ignoring the event, when in fact they are simply assigning a low probability to the worst case outcome (point 1 on the chart).  On the other hand you can have a high probability of the worst case outcome but the impact on the global economy is minimal (point 2 on the chart).  In either scenario the market is not ignoring the event it is instead assigning a joint probability of the worst case outcome which is low relative to the intensity of the news headlines.  Keep in mind analyzing geo-political developments is not static.  Market participants are re-assessing their views almost continually as new information is revealed.

With that background let’s focus on one of the issues of today’s world – the conflict between Russia and Ukraine.  Globalization, whether you are a fan or a skeptic, has created a significantly more interwoven global economy.  One of the benefits of this is the ability to source key basic materials from multiple points of origination.  Russia is an under-diversified country that is highly dependent on energy and basic material exports for their financial well-being.  As such there are economic constraints on the country which will impact how aggressively they pursue hostile expansion of their territory.  The ability for the world to divert sourcing to other global providers means there is a domestic cost to international overreach in Russia.  That does not guarantee they won’t attempt to go farther but until they push beyond what the global financial markets believe to be the limit, the direct impact on financial market performance will be subdued.  Referring to the chart this would be illustrated by point 1.

Another example from a few years ago would be the sovereign debt crisis in Europe.   Prior to more aggressive policy action and clear communication of intent by the European Central Bank (ECB) the fear in the market was that default contagion could spread from smaller, less significant economies to the larger countries at the core of the region.  Specifically economic contraction in Greece would have a very minimal impact on the global economy in isolation but as those issues spread to other countries without containment the impact became far more serious.  Graphically the impact dot was moving from the bottom left to the top right quadrants and financial markets became more agitated as this assessment changed.

Overall geo-political developments always carry the potential for the worst case scenario under which significant harm is imposed on the world economy and global financial markets, but it is not always wise to assume the worst case will occur.  The probability assessments of the extreme negative outcome by millions of market participants determine the actual impact, which may at times look out of sync because it is far less impactful than first contemplated.

Because of their fluidity geo-political events require daily monitoring; they are never a once-and-done analysis.   However by combining a macro-level top-down assessment of the probability of the worst case outcome with a bottom-up micro-level assessment of the fundamentals most at risk, an investor can be positioned to not emotionally overreact, understand if risk needs to be reduced or more money deployed to take advantage of the market’s knee-jerk reaction to any particular geo-political event.

Jack E. Payne, CFA, CFP

Chief Investment Officer