China and North Korea are among a variety of geopolitical risks that could impact markets in 2018. High net worth investors are in danger of taking such risks too lightly, and should instead seek well-diversified portfolios and consider hedges to mitigate the danger of abrupt corrections, suggest several family offices and independent asset managers.

Market commentators say geopolitical shocks are among their top concerns this year, at a time when many asset valuations are riding at high levels.

“If you ask me what the big risk is for this year, it’s geopolitical,” the Singapore-based managing director of a multi-family office, who declined to be named, told AsianInvestor. “It’s something that cannot be priced into portfolios, but when an event happens there can be serious implications for portfolios.”

China's increasing role amid a global leadership vaccuum was named as the top geopolitical risk of 2018 in a January 2 report by the Eurasia group in a January 2 rep, a political risk and research consultancy. Meanwhile, the Depository Trust and Clearing Corporation, a post-trade market infrastructure for the global financial services industry, released a survey on December 11 last year that identified geopolitical concerns in Asia and over the UK’s negotiations to leave the European Union left geopolitical risk as a top risk for 2018.

At a time when policy incoherence and dysfunction abound in Washington, China’s government has redefined the country’s external environment. Eurasia noted that the country is now promoting “the world’s most effective trade and investment strategy”, while using Chinese technology companies to advance state interests.

The consultancy believes there will be more US-China trade conflict this year, which is likely to have an implication on asset prices in both countries.

China's expansion globally could also lead to more push back from some Asian nations, and cause more friction in the South China Sea and over North Korea as well. A Natixis research report authored by Alicia Garcia Herero and Trinh Nguyen released on December 12 also cautions investors to keep an eye on “the increasingly intrusive role of China in Asia through the Belt and Road initiative [BRI],” which it sees a medium-term risk.

“The tide of support towards China for the BRI could suddenly come to a halt if countries were to be threatened by China’s intrusiveness in domestic—or bilateral—affairs,” it noted. 

For instance, as China continues to increase its economic ties with Pakistan through the Pakistan Economic Corridor, the risk of a stand-off in China-India relations can only increase, the Natixis report stated. That could have implications for investors looking to invest in either India or Pakistan.

Beyond India, a number of Asian countries are starting to worry about increasing dependence on China, not only as destination of exports but, more recently, as source of funding for infrastructure projects and outward foreign direct investment, the report added.

Other Asia concerns

Asia has plenty of other geopolitical issues competing for attention aside from China. Tensions between North Korea and the US continue to rumble on, while upcoming elections across South East Asia, while unlikely to trigger global contagion, risk causing enough market volatility to worry investors.

 The possibility of conflict on the Korean Peninsula remains the greatest geopolitical threat to credit quality in Asia during and beyond 2018, noted a January 3 report by Moody’s Investor Services.

“We consider a potential conflict to be a low-probability event, although the assessment of such a probability is highly uncertain.”

Physical damage would be the main challenge for Korean entities, in the event of a brief conflict. In a prolonged scenario, the impact on entities in other countries would come through disruptions to global trade and financial markets, Moody’s said in its report.

Eurasia also rated identity politics in Asia as a top geopolitical risk for 2018.

“Identity politics in southern Asia comes in several forms: Islamism, aversion towards Chinese and other minorities, and an intensifying Indian nationalism,” it noted in its report. This trend threatens the future of these increasingly prosperous regions, creating unexpected challenges for economic planners and foreign investors, it cautioned.

The outcome of upcoming general elections in Malaysia, Cambodia, Pakistan, Bangladesh and possibly Thailand, are, therefore, likely to be watched carefully by investors. In addition, four local elections are also due in India in 2018, and their results could set the tone for the crucial 2019 general elections.

“If the results are unexpected, there could be significant reversal in Indian equities, which are already highly valued,” the chief investment officer of a Mumbai-based multi-family office told AsianInvestor.

The benchmark Nifty 50 has risen by 30% since January 1, 2017, leaving it potentially at risk of a correction were the political landscape to become precarious.

Stay protected

These geopolitical risks leave investors cautious about the state of play in financial markets, particularly when so many public market valuations are perched at very high levels. The S&P 500, for instance, has risen around 22% at 2,751 over the past 12 months, while earlier this week (January 9), Europe's FTSE 100 scaled a new closing high of 7,731 on the back of buoyant retail news.

It might not take much in the way of rising tensions to cause a desire for profit taking or panic-selling, which could send markets into a steep sell-off—and dramatically affect investor portfolios. The trouble is, it’s hard to predict how likely this is.

“Geopolitical events are difficult to evaluate via stress tests as the scenarios developed are riddled with so many different assumptions,” Olivier d’Assier, head of applied research for Asia Pacific at risk consultancy Axioma, told AsianInvestor.

Geopolitical risks could have a particularly large impact on investors in regional equity markets such as India, where trading is highly liquidity driven, Prateek Pant, head of products and solutions, Sanctum Wealth Management, told AsianInvestor.

To guard against this, “investors need to continue to hedge their portfolios because market valuations are not necessarily in sync with fundamentals,” he added.

Experts recommend HNWIs stay invested across several asset classes and regions, to prevent their entire portfolios being caught out by geopolitical events. However, even this isn’t a guarantee.

“When a geopolitical event strikes, it hits every sector in the market. You can’t really hedge by choosing one sector over another—unless the event is targeted at one sector,” said Axioma’s D’Assier.

“Typically, investors need to hedge against market risk, and most developed markets have tools such as futures and options to help investors do that.”

Nevertheless, D’Assier believes a sense of complacency persists among many investors.

“Market volatility is low, while earnings and economic fundamentals are good, so the focus on geopolitical risk isn’t that high as it was two years ago, when the geopolitical agenda was heavier,” he said, adding that investors don’t feel like they need to protect themselves against these risks.

Harmen Overdijk, chief investment officer and co-founder of Hong Kong-based independent asset manager The Capital Company, agrees: he believes many investors underestimate geopolitical risk, which he said could turn out to be the biggest wild card of 2018.