The market is underestimating geopolitical risks The market is underestimating geopolitical risks The market is underestimating geopolitical risks

The market is underestimating geopolitical risks

Peter Garnry

Head of Saxo Strats

Summary:  Bubble stocks are up more than 20% this year in a sign of the comeback of reckless gambling behaviour by retail investors. This has been across massive speculation in zero-days-to-expiry options, ridiculous moves in AI-related stocks, and cryptocurrencies. It is all based on a blind spot towards the accelerating geopolitical risks and a naive hope of inflation coming back to the old past. The Munich Security Conference over the weekend has highlighted the growing geopolitical risks and this week is about appreciating these risks. In today's equity note we once again highlight our defence basket which has by far been the best performing basket over the past year.

Markets have gone risk blind in chase of ‘AI hype’ and hope of lower policy rates

The first seven weeks of the year has been a silly game played by investors and again increasingly by retail investors gambling in AI-related stocks due to humans’ extraordinary habit of extrapolating new technologies. Investors have also been playing the silly game of inflation going back to normal despite the growing evidence of structural inflation emerging and the world tilting into a war economy which historically has always been inflationary. This year’s performance in equity markets up 6.8% this year and bubble stocks 20.4%, as retail investors have come back with their gambling tendencies most evident in speculation in Tesla shares and zero-days-to-expiry (ODTE) options causing disturbances in liquidity and market behaviour, has wrapped reality in a glossy gift paper. Reality is unfortunately much more dark and the market is currently blind to this risk.

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.

Geopolitical Risk Index | Source:
Geopolitical Risk Index | Source:

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.


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