Measuring the market impact of geopolitics
In our recent Inescapable Truths we highlighted geopolitical risk as one of the potential disruptions investors will have to grapple with in the coming years. We argued that a heightened level of geopolitical risk, alongside other disruptive factors, would mean greater volatility in financial markets. Investor concern is apparent in surveys with geopolitical risk being regularly cited as the greatest tail risk for markets.
Here, we discuss the nature of geopolitical risk, its impact on the economy and markets and why we believe it is increasing.
Geopolitical risk - impact and outlook
The term geopolitical risk is used to describe a wide range of issues, from military conflict to climate change and Brexit. It relates to, but is not the same as, the risk posed by populism. For our purposes we are looking at the relationships between nations at a political, economic or military level. Geopolitical risk occurs when there is a threat to the normal relationships between countries or regions. From an investor perspective we are focused on how shifts in these relationships can impact the economy and create volatility in financial markets1.
The Geopolitical Risk index (“GPR”) is probably the most widely quoted measure and reflects automated text-search results of the electronic archives of 11 national and international newspapers. The index captures the number of mentions of key words such as military tensions, wars, terrorist threats or events2. Chart 1 shows the GPR back to 1985 with the clear impact of 9/11, after which the average level of geopolitical risk doubled. There has been a notable increase in the GPR index during the Trump presidency.
Chart 1. Geopolitical Risk: step change after 9/11
Source: “Measuring Geopolitical Risk” by Dario Caldara and Matteo Iacoviello at https://www2.bc.edu/matteo-iacoviello/gpr.htm. Schroders calculations and annotations, 11 April 2019
1 See for example the regular Bank of America Merrill Lynch (BoAML) monthly Global Fund Manager survey.
2 For more detail see “Measuring Geopolitical Risk” 9 November 2017 by Daniel Caldera and Matteo Iacoviello.
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