Geopolitics: Bonds and gold can help in temporary equity turbulences

The financial markets are under the spell of new geopolitical tensions. These have been triggered by a more hard-line policy on the part of the US re- acting to practices of Russia and China that it is no longer prepared to tolerate. In the medium term, equity markets are driven more by earnings and economic growth than by political events. In temporary phases of geopolitical uncertainty, bonds have historically performed well, while commodities such as gold have typically acted as a safe haven. Thus, bond and commodity modules are key components to hold as part of a complete portfolio.

The liquidation of people on British soil, which has been attributed to the Russian government, has led to the expulsion of 150 diplomats by the US and the UK, as well as – for the first time – sanctions against major Russian companies with close links to Putin. Are we seeing a return to the Cold War? At any rate, Russia’s more aggressive foreign policy ambitions ever since its annexation of the Crimean peninsula are gradually increasing geopolitical uncertainties. The Communist Party of China has removed the limits on the tenure of its President for the first time since the Mao era, making China too a form of dictatorship in which the President has unlimited power. This development has gone hand-in-hand with a more aggressive geopolitical stance, including the ongoing occupation of artificial islands not far from Singapore and the build-up of military facilities. Following the lead taken by Russia and China, President Trump has now massively increased military spending in the US as well, while at the same time expanding his influence. Very much like President Reagan in the 1980s, he is vigorously countering the more aggressive foreign policy of Russia and China. Although the dictator Assad has already won the civil war in Syria thanks to the active intervention of the Russian air force and support from Iran, he has now resorted to chemical weapons in an attempt to eradicate the final resistance, thus provoking a military response from the US. In short, geopolitical risks are on the rise due to foreign policy tensions. An investigation by the United States Trade Representative concluded that China’s economic policy is costing the US economy at least USD 50 billion a year, above all through illegal practices such as the theft of intellectual copyright on technology patents for the purposes of replicating such technology. Moreover, the US tariffs only amount to around a third of Chinese tariffs and about half the EU equivalent. In recent weeks the US has announced a 25% tariff increase on steel and a 10% increase on aluminium, while also threatening China with additional tariffs amounting to some USD 50 bn in import values. China has countered this move with the threat of 25% tariffs on 106 US products such as cars, aircraft and agricultural products, likewise with a value of USD 50 bn – to which Trump has in turn responded by stating that the US is now contemplating tariffs amounting to a further USD 100 bn on Chinese exports to the US. It may be added that geopolitical risks are also rising as a result of this increasingly bitter trade dispute.

Bonds in equity corrections, last 10 years

Source: Bloomberg

History highlights bonds as safe-haven investment
Historical precedents show that investors pile into bonds as a temporary safe haven in equity corrections (see graph) – just as gold is often in greater demand against a backdrop of geopolitical turbulence. Whereas equities can come under selling pressure due to the prevailing uncertainty, bonds – particularly those of governments or borrowers of high credit quality – tend to perform better during such phases. On the other hand, geopolitically- driven markets are usually short-lived: Equity market corrections driven by geopolitical events tend not to last long as they are overtaken by much more important factors in the medium term, such as corporate earnings and economic growth. In the Second World War, the defeat of France caused the Dow Jones to temporarily dive by 23%, and the German invasion of Russia did likewise. And yet the index rose by some 50% over World War 2 as a whole – i.e. by an annualized 7%. In the summer of 1950, communist North Korea invaded South Korea and the Dow Jones temporarily dipped by 11%. The ensuing conflict went on for three years, during which the index posted a rise of some 16% a year. In the autumn of 1962, the Cuban missile crisis brought the world to the brink of nuclear war between Russia and the US for a two-week period. The Dow Jones slumped 10% as a response, but was still 10% higher at the end of 1962 than it had been at the start of the year. When US President John F. Kennedy was assassinated in Dallas in 1963, the Dow fell 4.5% the very next trading day, but still ended the year 15% higher. US troops landed in Vietnam in 1965 and the Dow Jones lost 10%, the year ended with the Dow +10%. When the US was forced to withdraw from Vietnam without a victory in 1973, the Dow Jones had recorded an average annual rise of just under 5% for the duration of the conflict. Since gold was freed from its fixed rate of USD 35 per ounce, it served as a save haven. When Saddam Hussein occupied Kuwait in 1990, the Dow Jones fell by 13% while gold gained 8%. The Dow Jones had made good this loss just six months later. At around the time the Gulf War started in 2003, the Dow lost some 16% while gold appreciated by 20%. Once again, the stock market loss had been made good just six months later. The terrorist attacks of 11 September 2001 on the World Trade Center prompted a short-term price slump of 15% in the Dow Jones, while gold once again appreciated by 8%. Yet by December, the Dow Jones had clawed back all the lost territory. The overall conclusion to be drawn, therefore, is that geopolitical uncertainties do indeed trigger temporary price corrections in equities. Those who would like to reduce the corresponding risk should be expanding their portfolios to include bonds or commodities such as gold.

This publication is not intended to bring about the conclusion of a contract, but solely provides market and investment commentary by Maerki Baumann & Co. AG and an assessment of selected financial instruments. Hence, this publication does not constitute investment advice or an offer to buy or sell investment instruments. Maerki Baumann & Co. AG does not provide legal or tax advice. Maerki Baumann & Co. AG accepts no liability whatsoever for the contents of this publication. In particular, it does not accept any liability for losses or damage of any kind, whether direct, indirect or incidental, incurred as a result of using the information contained in this publication and/or arising from the risks inherent in the financial markets.

Editorial deadline: 17 April 2018

Maerki Baumann & Co. AG
Dreikönigstrasse 6, CH-8002 Zurich
T +41 44 286 25 25, info@maerki-baumann.ch
www.maerki-baumann.ch