This article first appeared in Forum, The Edge Malaysia Weekly on February 7, 2022 - February 13, 2022

Although the war drums have faded somewhat over Ukraine and the Taiwan Straits, a fundamental issue facing all asset managers is how to allocate funds strategically in the face of higher geopolitical risks, climate change, inflation and technology.

The World Economic Forum’s Global Risks Report 2022 had 89% of those surveyed perceiving the short-term outlook as volatile, fractured or increasingly catastrophic, while 84% expressed negative feelings about the future, being “concerned” or “worried”. This is not surprising, given the exhausting worries about pandemic lockdowns, health or jobs, plus an Omicron wave that has raised huge uncertainties on economic growth and recovery in 2022.

The biggest worry appears to be pandemic fatigue, as people are just tired of worrying, which explains why so many are partying or travelling locally, if not overseas.

Despite the media hype over war concerns, the Global Risks Report put geoeconomic confrontation as the 10th most severe risk, with the top five being climate action failure, extreme weather, biodiversity loss, social cohesion erosion (inequalities) and livelihood crises. Surprisingly, sovereign debt, which had grown 13 percentage points to 97% of GDP in 2020, ranked the debt crisis at No 9 in terms of severity of perception.

Furthermore, as stock markets reached record levels in the US towards the end of last year, veteran GMO asset manager Jeremy Grantham has signalled that the long bull market since 2009, when central banks first embarked on quantitative easing, may have “finally matured into a fully-fledged epic bubble”. He noted that “today, the price-earnings ratio of the market is in the top few percent of the historical range and the economy is in the worst few percent”. Of course, no one knows when that bubble will burst but last month, fears of the US Federal Reserve beginning to taper its asset purchases as inflation numbers rose caused a market correction worldwide.

Triggers to stock market adjustments are very difficult to predict, but events such as unexpected interest rate rises, financial failures, war and supply chain or commodity shocks, could suddenly spark a contagion effect across markets. Few have forgotten how Lehman Brothers’ failure triggered the 2008 global financial crisis. Lehman thought it was too big to fail and the US Congress felt that no institution should be too big to fail. When it was not rescued, the chain reaction of selling off all other highly leveraged financial institutions caused a market meltdown.

We have to factor in war risks into our investment decisions because war is unpredictable as to its trigger, scale, scope and speed of contagion. The classic story is the assassination of Austrian Archduke Franz Ferdinand on June 28, 1914, in Serbia. Austria wanted to punish Serbia with a short war, but that led to a Russian mobilisation and by Aug 4, the UK, Germany, Russia, France and Belgium had declared war on each other. History has shown that no European leaders wanted a war, but a series of accidents and blunders caused a devastating world conflict in a matter of weeks.

During World War I, the US securities markets depended very much on foreign funding, so when war was declared (although the US did not enter the war until 1917), the dollar-pound sterling rate initially devalued as European investors sold their dollar holdings and bought gold.

In World War II, the US again benefited from gold imports as European and other warring countries sold gold to buy imports of food and industrial goods, including armaments. The US benefited from inflows of flight capital, especially in gold holdings, which rose from just under 4,000 tonnes in 1922 to over 20,000 tonnes by end-1950. Since then, the US dollar has been the preferred currency of capital flight whenever geopolitical tensions rose.

The standard asset allocation is always a mix of stocks, bonds and cash equivalents. In the 1980s, portfolio managers moved into commodities, real estate and financial derivatives, collectively known as alternative assets. Diversification out of conventional assets occurred not only with mainstream asset managers, but also central banks, sovereign wealth funds and, more recently, family offices. For example, from 1990 to 2020, gold prices increased by about 360%, whereas over the same period, the Dow Jones Industrial Average gained 991% (investopedia.com). Gold has historically performed well in periods of high inflation or geopolitical tensions.

Since 2000, family offices that professionally manage the affairs of high-net-worth individuals (HNWIs) grew rapidly as they began to seek better returns. One of the world’s largest sovereign wealth funds (Norway’s Government Pension Fund Global) had an asset allocation of 72% in equities, 25.4% in fixed income, 2.5% in unlisted real estate and 0.1% in unlisted infrastructure. Its return since 1996 was 6.6%, with an excellent return of 14.5% in 2021.

In contrast, the Goldman Sachs Family Office Report 2021 noted that its average asset allocation to alternative assets (private equity, hedge funds, real estate and private credit) was as high as 45%. This implied that family offices are not adverse to risk. Although not that many are in cryptocurrencies, almost half of the offices are thinking about allocating some money in that direction.

Cryptocurrencies provide a new asset class that may be a shelter in the event of geopolitical risks. Since Bitcoin was invented by the anonymous Satoshi Nakamoto in 2009, the market value of recorded cryptocurrencies peaked at US$3 trillion, with several reasonably liquid trading platforms that make them a credible asset class.

Central bankers and mainstream commentators have described cryptocurrencies as having “no income, utility or relationship with economic fundamentals”, bordering on Ponzi scams. But once Facebook started exploring the issue of its own digital currency, there were signs that the usage of cryptocurrencies was rapidly moving into the mainstream, as Tesla and other prestigious retail brands have indicated that they will accept certain cryptocurrencies for payment.

In 2021, Bitcoin returned 59.8%, Ethereum (smart exchange platform) 399.2% and Binance Coin (an exchange token) 1,268.9%. Thus, many young investors who experimented with buying or trading cryptocurrencies seem to have done well, as many crowded into these new tokens.

The main attraction of digital currencies is that they offer anonymity from official surveillance for tax, money-laundering, regulatory or national security purposes. The second attraction is that the cost and convenience of transactions is faster and cheaper than using conventional banks. It is estimated that foreign exchange transactions in small amounts through retail banks and money changers may cost as much as 7% of the amount remitted. Thus, a young netizen can buy and sell non-fungible tokens (NFTs) for digital artworks very quickly and conveniently. Both buyers and sellers would have to do sufficient due diligence to make sure that their transactions are secure and not subject to scams or theft, including the loss of encryption codes.

Although central banks are now increasingly inclined to regulate cybercurrencies on the basis that if it behaves like a currency, has uses as a currency and feels like a currency, then it should be regulated on the same level as fiat currencies. Notice that since China banned the mining of private cybercurrencies, the mining activity has shifted to the US and turnover has increased.

My own assessment is that cryptocurrencies, like the coronavirus, are here to stay, even if many may fail. A few would be very successful and eventually become the benchmark for other cybercurrencies.

Are cybercurrencies useful stores of value during times of volatility and conflict? Frankly, my guess is that if the internet cannot be taken down by global hacking or viral attacks, then cryptocurrencies will survive. But we can never be sure whether in a futuristic cyber war, the internet can be brought down, causing investors to lose access to their holdings of cybercurrencies.

Remember that in the event of a total nuclear war, there are no perfect assets or safe harbours. International financial centres where current stocks, bonds and securities, including gold, are held in custody may be destroyed. If you live in a zone of peace, without the threat of nuclear or terrorist wars, then conventional banking and assets under management should be relatively safe.

There are assets like art or wine that may suffer significantly in times of conflict, but may do spectacularly well in times of peace. Each asset has its own unique characteristics in terms of liquidity, return, risk and convenience. Basically, understand carefully what you are actually buying, because you may not be able to sell it easily in times of volatility. As usual, caveat emptor, or buyer beware, applies to all investments.

Tan Sri Andrew Sheng writes on global issues that affect investors

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.