When should we care about geopolitical risk?

The power of Cycle, Value and Sentiment

As our clients know, at Russell Investments, we believe in the power of a consistent and coherent investment process to guide us in our asset allocation decision making. Not only does a good investment process paint an insightful picture of where the risks and opportunities lie, it also helps avoid the most common behavioural finance mistakes. However, even a well-thought-out investment process has its limitations. No process can cover everything that potentially impacts financial markets.

Geopolitical events and their associated risk are technically out of scope for our investment process. But that does not mean they’re out of mind.

When we designed our investment process, we settled on three building blocks: Cycle, Value and Sentiment­­­­­. These building blocks represent what we believe are the three fundamental drivers of investment returns, and are designed to take advantage of potential opportunities. Depending on our investment horizon, we give them different weights to account for their underlying characteristics.

  • Cycle covers the medium term.
  • Value is the quintessential long-term driver of investment returns.
  • Sentiment is short-term oriented.

How Cycle, Value and Sentiment address geopolitical risk

We use Cycle, Value, and Sentiment in our analysis of geopolitical events that have already occurred and geopolitical risks that are still on the horizon.

Outside of a major war, an enormous natural disaster or widespread epidemic, we believe it is unlikely a geopolitical event will have a lasting impact on value. Thus, after a geopolitical event we can use our Value scores to indicate if the resulting move in financial markets has been big enough to be meaningful. We can also use our Value score to indicate the potential impact of a geopolitical risk. In particular, when markets are expensive, geopolitical risk is to be taken seriously as a possible catalyst for a reversal. In that sense, our Value scores act as a risk indicator for the potential impact of a geopolitical event.

In contrast geopolitical events or risk are basically par for the course for Sentiment. Our Sentiment scores are specifically designed to respond to market volatility and investor behavior. As such, Sentiment will tell us whether the change in financial markets was abrupt enough to push investors into a state of euphoria or fear. However, because Sentiment is attuned to the response to a geopolitical event as opposed to the event’s character, it does not answer the question as to why markets are moving. And as such, it does not give us insight into whether the move is warranted or overdone. For that we need Cycle.

When we are confronted with a geopolitical event that is both meaningful and abrupt per our observations in Value and Sentiment, we quickly zoom in on the question at hand: has our outlook for the Cycle changed?

If the geopolitical event or risk is expected to change the course of the business cycle, then we want to reflect that in our Cycle, Value, and Sentiment scores. And because that change would run contrary to the changes in Value and Sentiment, it will automatically validate the geopolitical event as significant enough to warrant caution. Of course, the opposite also holds. If we don’t believe the geopolitical risk or event is significant enough to change our Cycle score, then we automatically allow Value and Sentiment to determine when to respond to market volatility.

So, what are these three building blocks telling us now?

Looking ahead, we believe we are past the peak of geopolitical risk, despite a busy European election calendar.

Both Brexit and the election of Donald Trump were events with a real impact, but neither changed the course of our global cycle score. That may not be the case if Marine le Pen wins the French presidency. However, we continue to believe that election result is unlikely.

And even if it does occur, we believe our investment process will take it into account.