Geopolitical risks, asset pricing and portfolios

Geopolitical Risks, Asset Pricing and Portfolios

Historically unprecedented geopolitical risks are influencing and weighing down the global economic and financial system. Geopolitics is affecting not just the major large economies but also the smaller emerging market economies. Geopolitical events of the last three or four years have affected economic growth, international trade, economic fragmentation as well as asset prices (equities, bonds, sovereign premia, commodity prices, currency prices) and the role of the dollar. Geopolitical risks (GPR) affect all countries; however, the magnitude and timing of the effects vary. It is very important for investors to consider and factor in GPRs as they influence both the returns and risks of investment portfolios.

Until recently, the debate on geopolitics was largely qualitative and dominated more by political and journalistic commentary. International affairs and global experts Sam Huntington, Francis Fukuyama and Martin Wolf have commented and opined on the linkages between geopolitics, state of law and order and its links to economic stability, economic powers and trade blocs. The recent development by Fed researchers of a quantitative index to measure GPR has been welcome. The Geopolitical Risk Index (GPRI) provides a way to assess the quantitative impact of geopolitics on macroeconomic fundamentals as well as asset prices. It also means that the swings and tumbles in the geopolitical world affect both global economic and investment conditions systemically.

The latest updated chart of the GPRI is below, and it illustrates the increase in Geopolitical Risks over the last five years. In addition, there has been an uptrend in financial and trade sanctions over time too.

The next important issue is how do GPRs transmit onward to Asset Prices? A nice schematic by the IMF in their Global Financial Stability Report shows it very clearly. The chart synthesises both classical and modern behavioural finance to explain the transmission on to asset prices. GPRs transmit to asset prices through two channels – the economic channel and the sentiment channel. Note that both physical and financial assets are impacted by GPR changes.

Gita Gopinath (2024), formerly of the IMF, highlighted the fact that the global economic landscape is being transformed in ways different from the earlier post-World War 2 world with multilateral rules framework and institutional structure. She shows that trade restrictions across goods, services and investments have tripled and financial sanctions have increased. She asserts that geopolitical blocs – pro-China, pro-US, and neutral – are shaping trade and investment in an increasingly fragmented global economy. Gopinath argues that while the current economic fragmentation is similar to the initial Cold War period, it is likely to be much costlier today due to a higher share of trade to GDP (~46%).

Gopinath found that geopolitics has not yet affected the dominant role of the USD in both Trade Finance (80%) and as a Reserve Currency (~60%). The IMF’s managing director Kristalina Georgieva cautioned that geopolitical fragmentation could reduce global GDP by 7% in the long term.

IMF Research teams also found that average equity returns drop after major GPR events post WW2; further, the average monthly drop is 1% across most countries but a much larger 2.5% drop across EM economies.

A Mattoo, M Ruta and R Staiger (2024) study Geopolitics in the context of US-China rivalry and the current diminished status of the WTO. The current heightened geopolitical rivalry seems to have undermined the WTO. They state that the WTO can continue to thrive as a forum for multilateral trade cooperation if it adapts in a measured way to current geopolitical strains.

S Aiyar, D Malacrino and A.F Presbitero (2023) assess the role of geopolitical alignment in Foreign Direct Investment (FDI) flows testing whether friendshoring helps to lessen the impact of geopolitical tensions. They show that slowbalisation (slowdown in globalisation, post GFC) resulted in FDI declines from 3.3% of GDP (2000s) to 1.3% (2018-2023). They state that while many factors like automation and technological change could be responsible, the emergence of fragmentation of capital flows along geopolitical lines and potential emergence of regional blocks are newer factors.

But how do GPRs affect countries and assets? Does it vary across countries and regions? The Table below answers the question and displays the average weekly cumulative changes in asset prices. It shows the differences across advanced economies, emerging markets and developing economies (EMDEs), commodity exporters and commodity non-exporters too.

Commodity-importing countries tend to suffer more, whereas commodity exporters often experience positive stock returns after major geopolitical risk events. Tariff announcements by the US and China between 2018 and 2024 negatively impacted stock prices; following US announcements, Chinese firms saw nearly a 4% decline. But some tariff announcements affected stock returns by up to 8% as in May 2019.

In conclusion, I believe that geopolitical risks are systemic and are affecting the investment climate with both short-term and longer-term effects on macro fundamentals (growth, debt and inflation) as well as on asset prices. Changes in asset prices and risk preferences in an era of heightened GPRs and a geo-fragmented world necessitate careful monitoring and management while constructing resilient portfolios.

Amlan Roy is the author of Demographics Unravelled and founder of Global Macro Demographics Research. He is a research associate at the London School of Economics and an honorary fellow of the Institute and Faculty of Actuaries. He is also a partner at LCP.