SSGA: How to position for geopolitical shocks in 2024

March 28, 2024

Most risk assets seem to be pricing in a benign macroeconomic environment. State Street Global Advisors, however, examines the most appropriate and easily implementable portfolio strategies for investors who believe that these calm market conditions inadequately reflect the balance of risks.

What Risks are We Thinking About?

• Global supply shock scenario: Currently, the most compelling threat would arise from a flare-up in the conflict between Israel and Hezbollah on the Lebanese-Israeli border; could lead to disruptions in Gulf shipping and oil production
• Regional crisis scenarios with risk-off spillover: There are multiple plausible scenarios, for instance in North Korea, Taiwan or a confluence of simultaneous crises in less economically central regions (e.g., VenezuelaGuyana and other smaller oil producers)

Suitable Portfolio Strategies Given the Context

The choice of tools to put in place in the context of the above scenarios varies in complexity. For investors who are at the simpler end of the spectrum, State Street Global Advisors suggests the following strategies:

• Long Commodities or Energy Our base case view is a gradual increase in energy prices toward year-end due to recovering energy demand. However, any commodity shock could deliver a rapid price spike. There are plenty of other scenarios as well where commodities are less effective and there is demand destruction even. We, therefore, believe that going long commodity volatility may offer a better proxy exposure.
• Long Gold In addition to a separate view on commodities, a singular exposure to gold can potentially help navigate macroeconomic risks. Historically, on average, in high volatility periods when the VIX Index rises, gold prices have outperformed other traditional risk mitigators such as bonds, Treasury bills, and defensive equities.
• Relative Value Defensive Equity Sectors If macroeconomic risks arise and sector behavior reacts similarly as it did during past events, then focusing on defensive sectors while seeking to neutralize market beta can potentially be additive. As a result, a relative value macroeconomic sector position could be entered by going long defensive sectors (utilities, healthcare, and consumer staples) while shorting the broader overall market in either a dollar- or beta-neutral basis.

For investors with access to more complex hedging tools, derivatives could prove to be compelling this year. Below are our views on derivatives strategies that reflect the distribution of risks:

• Vulnerable FX The flipside of safe-haven flows is outflows from negatively affected currencies. The most attractive is EUR/USD among large US dollar currency pairs that are beta-positive to the global economy, given that Europe is centrally exposed to most risks. The euro options market also currently exhibits historically low levels of implied volatility and the forward curve remains favorable.
• Sovereign and Corporate Credit Default Swaps (CDS) Sovereign CDS are relevant for geopolitically vulnerable countries, particularly those near conflict zones; large energy importers; or economies with a large beta to global economic growth. In the absence of a defined central risk scenario, the generic widening of risk premia is well captured here. As far as corporate bonds are concerned, credit spreads tightened across both investment grade and high yield (HY) during 2023, bringing both to the low end of their historical ranges. Within HY specifically, a strong preference for quality has driven higher-rated debt spreads (BB and B) near 20-year tights, while lower-rated CCC spreads hover slightly below their 20-year average. The combination of BB and B spreads hovering at historic levels of tightness and the increased beta in CCC debt leaves HY spreads particularly vulnerable in a risk-off event.
• Volatility We are near historically low levels of implied volatility in most asset classes, which could mean current calm market conditions could reset at a higher floor. Past experience also suggests that volatility moves sharply, not incrementally, in the event of a regime change.

'As 2024 unfolds, there are several global and regional risk scenarios that may throw cold water over the benign macroeconomic environment that markets seem to have priced in for the year. History also suggests that benign market conditions frequently experience sudden market regime shifts. Given this context, the spectrum of strategies, ranging from the simple to the complex, that we have illustrated above should provide a healthy choice for investors in the event of a risk-off environment,' Elliot Hentov, Head of Macro Policy Research says.