Impact of Current Geopolitical Environment on Asset class returns in India

Posted in Finance Articles, Total Reads: 1143 , Published on 20 February 2015
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What are Geopolitical Risks and how Geopolitical risks effect Investments?

While many of the markets have become stable if not comforting after the recession, Geopolitical events have caused brief bouts of volatility in 2014 fortunately without knocking global markets off their trajectory. Factors like tensions between Japan and China over East China Sea, Russia tightening its muscles in Ukraine and beyond, increased terrorist activities of ISIS and so on in the era of globalization have created a new math of risk for investing community.



The graph shown below from taken from article by Erik L. Knutzen, CFA, CAIA Chief Investment Officer – Multi-Asset Class, showcases how a geopolitical risk sharply increases volatility in the market:-


Fig: 1, Source: FactSet, Neuberger Berman. VIX: Volatility index (Accounts for Geopolitical risks and investors’ concern)


The higher level of volatility has a direct impact on investment portfolios. It adds to the level of concern and worry on the part of investors as they watch the value of their portfolios move more violently and decrease in value. This causes irrational responses by the market which can increase investors' losses to great extent.

Importance of Geopolitical risks in the new multi-polar world

The percentage contribution by different regions of the world is changing drastically as may also be seen below in graph. US and Eurozone (Germany) are losing a major chunk of their contribution in world’s GDP to Asian economies like India and China.


Fig 2, Year wise percentage contributions by various countries in terms of PPP


The US share of global GDP, around 25% in 1980, declined to 19% in 2011, and is expected to slip to 18% in 2017, by which point China is expected to overtake the US. In this background, regional leaders especially some Asian countries have become more vociferous and reaching a consensus has become difficult. Since the financial crisis, G-20 has replaced G-8, after which the Doha Round negotiations collapsed, the Copenhagen Conference failed to reach an important climate agreement and recently India did not sign World trade agreement. China launching World Bank’s rival AIIB in Asia and story of BRICs development bank also inks the fact that world has become multi-polar today.

The multi-polar world carries great risks, notably that major global challenges will go unmet, because no single country would be able to convince a single global consent. The weaknesses of global policy cooperation in this sense are worrisome. Thus, Investors face an unprecedented range and degree of geopolitical risks today. The graph Shown below showcases the increasing number of fund managers seeing geopolitical risks a major worry.


Fig 3, Increasing number of Fund managers feeling Geo-political risks, Source : BOA, Merrill lynch


Different asset classes with historical performance

Equities:-


Fig 4: Analysis of Indian Equity return (All values Taken start). Source: S&P BSE index (Moneycontrol.com)


As may be seen, the Equity index has steadily moved upwards over the years but is accompanied by lot of volatility or risk. An investment of 5210 in 2000 would have resulted in 21000 in 2014 but also there was risk of no return in first 3 years.

The key indicators from this data are:-

Asset Class

Annualized return

Standard Deviation of returns

Total Loss to profit return ratio

Highest positive return

Highest negative return

Equity

22%

0.41

0.81

44%

-109%

Table no. 1


Further the graph below shows the behavior of this asset class with respect to the perceived strategic country risk (India) on Quarterly basis.


Fig 5: Analysis of Indian Equity return with India risk score. Source: www.strategicriskindex.com and S&P BSE (moneycontrol.com)


From this it may be seen that, on quarter to quarter basis, equity index is largely independent of Indian Risk rating. The correlation coefficient also is 0.05 which also indicates the same.


Real estate:-


Fig 6: Analysis of Indian real estate return. Source: NHB Residex (Delhi)


It has been observed that the returns are positive most of the time and the volatility is low, confirming its association as growth and defensive asset.

The key indicators of this are:-

Asset Class

Annualized return

Standard Deviation of returns

Total Loss to profit return ratio

Highest positive return(QTRLY)

Highest negative return(QTRLY)

Real estate

10%

0.04

0.16

10%

-5%

Table no. 2

As the standard deviation is low and total loss to total profit ratio is also low, this is a relatively safe investment with a good annualized return of about 10%.


The graph below shows the correlation of country risk perception with Real estate investments on quarterly basis.


Fig 6: Analysis of Indian real estate return with perceived country risk. Source: NHB Residex (Delhi) and www.strategicriskindex.com

An average positive correlation between country risk and return in real assets with correlation coefficient of 0.16 is observed. This implies that there are chances of real estate being affected by country risks.


Fixed income:-


Fig 7: Analysis of Indian Fixed Income returns. Source: NSE India


On analysis it is observed that there has been only one instance of negative return in all these years and the growth has been relatively smooth, even in the times of financial crisis.

The key indicators for this are:-

Asset Class

Annualized return

Standard Deviation of returns

Total loss to profit return ratio

Highest positive return

Highest negative return

Fixed income

11%

0.04

0.01

14%

-1%

Table no. 3

As calculated, the return rate is good with considerably no risk of negative return in this investment.


Now, the following graph shows the correlation between country risk score of India and Quarterly returns.


Fig 8: Analysis of Indian Fixed Income returns with country risk. Source: NSE India and www.strategicriskindex.com


The correlation factor here is -0.3 indicating that people tend to invest more and to some extent return on this asset class increases with perception of country risk.



Commodities:-


Fig 9: Analysis of Indian commodity (Gold) return (All values Taken start). Source: www.investing.com


The key indicators for this asset class are:-

Asset Class

Annualized return

Standard Deviation of returns

Total loss to profit return ratio

Highest positive return

Highest negative return

Commodity (Gold)

43%

0.14

0.01

41%

-1%

Table no. 4


From the key indicators it is observed that Gold as a commodity has provided impressive annualized returns of about 43%.

A very low loss to profit ratio and almost no negative return, it is one of the safest investments in medium-long term. However, a standard deviation of 0.14 indicates towards volatility and it may be observed that in last 3 years the returns have gone down from 41% to -1%.


On analyzing the correlation between this asset and country risk score on quarterly basis the graph obtained is as below:-


Fig 10: Analysis of Indian commodity (Gold) return (All values Taken start). Source: www.investing.com and www.strategicriskindex.com


From graph it may be observed that value pricing of Gold and country risk perception has high correlation. The correlation factor is 0.52, which is high and indicates that there is chance of commodity asset being affected by the country risks.

Major Countries playing role in Geopolitics and their strategic risk rating

It can be acclaimed that the geopolitical risks are primarily combination of one or more involved countries. As such this shall have a major effect on their country risk score. Various countries having geopolitical impact on India are shortlisted and their risk correlation with India risk scores is done (on quarterly basis) to gauge the inter connectedness of economies as shown :-


India

South Africa

Iraq

Iran

Israel

Saudi Arabia

UAE

Russia

Turkey

Germany

China

Japan

Brazil

US

Oct'11

5.9

4.6

7.1

6.2

5.4

4.2

3.2

4.9

4.2

2.6

4.8

3.6

4.4

1.8

Jan'12

6

5

7.1

6.3

5.3

4.5

3.5

4.9

4.4

2.5

4.8

3.6

4.4

1.8

Apr'12

6

5

7.1

6.4

5.3

4.6

3.6

4.9

4.8

2.6

4.8

3.5

4.4

1.8

Jul'12

6.1

5

7.2

6.4

5.4

4.6

3.7

5

4.9

2.5

4.9

3.6

4.2

1.8

Oct'12

6

5

7.3

6.4

5.2

4.6

3.7

5

4.9

2.4

5

3.5

4.3

1.8

Jan'13

5.9

5

7.4

6.5

5.4

4.5

3.7

5

4.9

2.4

4.9

3.6

4.3

1.9

Apr'13

5.9

4.8

7.4

6.5

4.9

4.5

3.7

5

5

2.4

4.8

3.7

4.3

1.9

Jul'13

5.9

4.8

7.4

6.5

4.7

4.5

3.7

4.9

5.3

2.4

4.8

3.2

4.6

2.1

Oct'13

6

4.8

7.1

6.1

4.5

4.5

3.6

4.9

5.7

2.5

4.9

3.4

4.6

2.2

Jan'14

6.1

4.8

7.2

6.2

4.4

4.5

3.6

5.2

5.6

2.4

5

3.4

4.3

2.2

Apr'14

6.1

4.8

7.3

5.9

4.4

4.5

3.6

5.4

5.6

2.4

5.1

3.5

4.3

2.2

Jul'14

6

4.8

7.6

6

4.4

4.5

3.5

5.4

5.6

2.4

5.1

3.5

4.4

2.2

Oct'14

6

4.8

7.2

-

4.4

4.5

3.6

5.5

5.5

2.4

5.1

3.6

4.4

2.3

Correlation  with India

1

0.23

-0.24

-0.52

-0.32

0.44

0.15

0.44

0.41

-0.07

0.55

-0.07

-0.40

0.27

Table no. 5, Source: Quarterly reports (www.strategicriskindex.com)

What these risks mean for Different asset classes

Now to calculate considerable measure of Geopolitical risk, the degree of current political risks of individual countries with their correlation coefficient have been multiplied and added (Correlation for India would be 1).

Geopolitical risk for asset class in India= Country Risk Relation* Indian Geopolitical risk Factor

Where, Indian Geopolitical risk Factor = ∑Country’s correlation to India*Country’s risk Factor

= 1*6+0.23*4.8…. +2.3*0.27 =12.42 (From table no. 5)

This number is further multiplied with the correlation coefficient of asset class with country risk. This provided us the considerable geopolitical risk rating of the asset class on scale of 10, which was further reduced to scale of 1 for further calculations. Finally we receive the various geo-political risk factors for different asset classes as follows:-

Asset Class

Country Risk Correlation

Indian Geopolitical risk Factor

Geopolitical risk for asset class in India(1-10)

Anticipated Geopolitical risk factor in India (Scale of 1)

Equity

0.05

12.42

0.65

0.06

Fixed Income

0.17

12.42

2.08

0.20

Real Estate

-0.33

12.42

-4.07

-0.40

Commodity

0.52

12.42

6.49

0.64

Table no. 6


Risk returns profile for different asset classes

Final risk return profile for different asset classes is obtained as follows:-

Asset Class

Average Annual return

Average Volatility (a)

Loss to Profit ratio

Anticipated Geopolitical risk factor in India

(Scale of 1) (b)

Total Risk

(a+b)

Equity

22%

0.41

0.81

0.06

0.47

Fixed Income

11%

0.04

0.01

0.20

0.24

Real Estate

10%

0.04

0.16

-0.40

-0.36

Commodity

43%

0.14

0.01

0.64

0.78

Table no. 7

From the above table, it may be seen that real estate is the safest investment when it is about factoring geopolitical risks and other market risks. But the returns in real estate are relatively very low. The commodity on other hand returns heavily but carries huge risks.


Recommended Portfolio composition

A suggested mixture of investment for medium-long term in the asset class based on geopolitical risks is as shown in pie – chart. The premise here is that the total risk factor of the portfolio should be near to zero. As commodity risk is twice and acts reversely to the Real estate, the ratio of real asset to commodity investment is suggested about 2. Equity is added to balance the portfolio overall risk with good returns. Fixed income can replace equity investment if more risk avoiding portfolio is desired.


Fig. 11, recommended portfolio, accounting for return and geopolitical risks.



This article has been authored by Mohit Kumar from IIM Shillong


References

• The Economist

• Carnegie Endowment for International Peace,New Geopolitics by David Rothkopf, Celso Amorim, Thomas Friedman,Susan Glasser, Jessica Tuchman Mathews

• http://www.nseindia.com/products/content/equities/indices/historical_total_return.htm

• http://www.moneycontrol.com/stocks/hist_index_result.php?indian_indices=4

• http://www.investing.com/rates-bonds/india-10-year-bond-yield-historical-data

• http://www.nseindia.com/products/content/debt/wdm/gove_sec_index.htm

• http://www.strategicriskindex.com/

• http://www.slate.com/articles/business/moneybox/2006/07/the_hellinahandbasket_index.2.html

• The Fletcher School, Building Capacity for Geopolitical Risk Analysis by Dr. David A. Glancy

• https://in.finance.yahoo.com/echarts?s=GCC#symbol=GCC;range=1d

• http://www.knowledgebankiq.com.au/KBIQ/media/Media/Articles/Investment-insight-geopolitical-risks.png

• Investopedia

• http://www.social-europe.eu/2012/04/the-challenges-of-a-multipolar-world



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