The market is underestimating geopolitical risks

Geopolitical risks are underestimated by the market

Nervousness was felt at the Munich Security Conference over the weekend and this rundown by Politico is excellent. The key take-aways are that ammunition production is neither standardized as thought and too slow in NATO. One has the sense that Europe is one inch from moving into a more war economy type mentality when the standard rules are thrown away in favour of fast tracking permits for weapons production and unlimited government support for weapons manufacturing both in terms of financing and infrastructure. In addition, the US vice president Kamala Harris now says that Moscow has committed crimes against humanity in Ukraine which is sharp escalation in the rhetoric. US Secretary of State Blinken also said that the US is fearing that China may provide Russia with lethal weapons in the war in Ukraine.

With the one-year anniversary of Russia’s invasion of Ukraine, US and China on collision course, and the sense of nervousness at the Munich Security Conference, this week about appreciating the potential rising geopolitical risks. If China decides to aid Russia with weapons then globalisation as we know it is over and supply chains will be tossed into chaos once again. The Geopolitical Risk Index, which is compiled by Fed economists Dario Caldara and Matteo Lacoviello, shows how geopolitical risks have come down since the start of Russia’s invasion of Ukraine underscoring the seeds of our current complacency in equity markets. If one broadens out the perspective of geopolitical risks we can see that the upside risks are considerable should the war in Ukraine take a turn for the worse.

Equity markets have always been reacting negatively to rising geopolitical risks, but after the initial shock equity markets have shown considerable strength and recovered fully. This has been evident during many of the wars including WWII, and the Korean War from 1950-1953 did not even cause a significant risk to equities. These findings might make comfortable, but we should appreciate that the global economy is much more interconnected than before because of the 50-year long globalisation. Our wealth and income are more sensitive to an acceleration in geopolitical risks than ever before. The price on geopolitical risks is clearly negative in the short-term and longer term the price could remain high through structurally higher inflation. There has been a war with low inflation as a war economy bids up the price for ressources.

Defence stocks will continue to thrive

With geopolitical risks on the rise the only meaningful hedges for investors are either reducing market risks by lower equity exposure (selling positions to increase cash position), reducing market risk by selling equity futures, or adding defence stocks to the basket. Our defence basket is up 31% over the past year surpassing in length the second best performing basket which is renewable energy up 12%. As we have repeatedly said in equity notes the past year defence budgets in Europe are set to double and with that create a tsunami of growth in the defence industry. The theme is definitely not ESG which is in fact to the advantage of the retail investors because this class of investors are not ESG constrained.

On Thursday, one of the stocks in the defence basket, BAE Systems will report FY22 2H earnings (ending 31 Jan) with analysts expecting revenue growth of 23% y/y and EPS of £0.30 up 250%. Looking ahead analysts have very low expectations for revenue growth in 2023 of 3% and 5% in 2024, which means that there is room for a considerable upside to the growth outlook.