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Geopolitical risk isn't going away any time soon

Global markets swooned on Friday as news of U.S. authorized air strikes in Iraq raised concerns of escalating geopolitical tensions and market watchers expect the overhang to remain for some time.

In Asia, Japan's Nikkei 225 took the largest hit, tumbling over 3 percent, as investors flocked to safe haven assets such as the yen and gold. The Japanese currency strengthened 0.3 percent against the U.S. dollar, while spot gold rose 0.2 percent.

In a press conference late Thursday, U.S. President Barack Obama announced his authorization of targeted airstrikes in Northern Iraq to protect American personnel. The airstrikes would be the first carried out by the U.S. military in Iraq since the withdrawal of its forces at the end of 2011.

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"Geopolitical risk is the most influential force in markets right now. Markets are worried this may be a longer-term game for the U.S. in Iraq, and that's why you're seeing the risk-off trade emerge so fast," Evan Lucas, market strategist at IG told CNBC.

"There is a high degree of uncertainty as we'll need to see what happens following the initial response of targeted airstrikes and whether the U.S. needs to put troops back on the ground," he said.

Obama's announcement comes amid mounting tensions in the Middle East and Eastern Europe, with a build-up of Russian troops on Ukraine's eastern border fueling further concerns of conflict. The head of NATO on Thursday called on Russia to "step back from the brink" of war by pulling its troops back from the Ukrainian border and warned further intervention in Ukraine would bring it greater isolation in the world.

Traders on the floor of the New York Stock Exchange.
Getty Images
Traders on the floor of the New York Stock Exchange.

Bigger threat: Iraq or Ukraine?

David Riedel, president and founder at Riedel Research Group expects the situation in Ukraine will be a bigger threat to markets than U.S. airstrikes in Iraq.

"I think limited air strikes by the U.S. are going to be seen as a humanitarian mission, saving some of the communities that have been so badly attacked by ISIS in Northern Iraq," Riedel said.

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"It's the real war between Russia and Ukraine that really worries markets the most. You're going to see a growing amount of pressure on [Russian President] Vladimir Putin who is painted into a corner with sanctions," he added

Moscow on Thursday announced that it was hitting back at Western sanctions by banning certain agricultural and food imports. The ban includes fruit, vegetables, meat, fish, milk and dairy imports from the United States, the European Union, Australia, Canada and Norway.

"With [Putin's] domestic popularity being extremely high, and success surrounding the rebels in Eastern Ukraine those are really putting him a very tough position, I don't think any of the outcomes in Russia and Ukraine are good," he added.

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Manpreet Gill, senior investment strategist at Standard Chartered Bank, agrees targeted airstrikes in Northern Iraq will have a limited impact on financial markets.

"Unless violence spreads to oil producing regions in Iraq, the financial market impact from this issue alone is likely to be fairly well contained," he said. "Indeed the fall in oil prices seems to suggest much of this risk has already been priced out."

Positioning for geopolitical risks

With geopolitical risks set to remain a dominant theme in markets, Lucas of IG recommends investors go long on volatility, via the CBOE Volatility Index, or VIX.

The VIX, called the "fear gauge" because it usually moves in the opposite direction as the S&P 500, rose 1.77 percent to 16.66 overnight.

Others recommend that investors use the current selloff as an opportunity to add on to stock holdings.

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"For somebody who is thinking long term and has a bit of risk budget, I would insist on buying dips.I think the overall bull market regime is still intact," said Mikio Kumada, global strategist at LGT Capital Partners.

Situations like this highlight the importance of holding a diversified portfolio, Kumada said, with safe haven assets such as gold, which perform well in a risk off environment.