The evolution of geopolitical risks

Geopolitical risks appear to be a recurring theme impacting global markets and can have a significant influence on the short and medium term direction of asset prices. ‘Political risk’ and ‘geopolitical risk’ are terms often used interchangeably, but for analytical purposes, it can be useful to distinguish between the two.

Political risks often refer to instability in a country’s leadership or institutions that can have an impact on policy and macroeconomic outlook, while also influencing market returns and volatility.

Geopolitical risks tend to refer to the impact of one country’s foreign policy on another country or region, and the potential economic and military conflict that could arise. In a world of increased globalisation, the lines between the two are increasingly blurred, and they can both have an impact on investor sentiment and market performance. Here I will talk about both as one and refer to it as geopolitical risk.

The chart below shows the recent history of the biggest ’tail risks‘ for markets from Bank of America Merrill Lynch’s monthly Global Fund Manager Survey. Since the Global Financial Crisis (GFC), the sovereign debt crisis in Europe and the instability in the region took centre stage, while slowing Chinese growth has been a persistent concern for investors. However, in recent years, the rise of populism and geopolitical issues have dominated investors’ concerns, particularly fears of escalating trade wars. The World Economic Forum has also consecutively cited geopolitics as the number one risk to global stability for the past three years.

It’s fair to say that geopolitical stresses have been the norm and not the exception since the beginning of the twentieth century. However, for the most part, the outcome of tensions has been largely benign for the longer-term health of developed financial markets – with the exception being the oil price shocks of 1973, 1980 and 1990, which precipitated three of the past six US recessions and had a larger impact on the broader market, given the global reliance on oil. We have continued to witness oil price spikes, most recently due to the rising tensions between the US and Iran, and supply risks from Venezuela, but these spikes are becoming less pronounced due to structural industry changes, including a greater diversity of supply, the US Shale boom and changing demand dynamics partly due to policies to promote green energy.

Given the waning influence of oil prices as a trigger for geopolitical unrest, what other factors are driving geopolitical instability?

With increased globalisation, and through the rise of technology and social media, we’ve witnessed growth in the reach and immediacy of information. Since President Trump’s election in late 2016, newsflow around themes such as trade wars, terrorism, missile tests and cyberattacks has surged.

Led by Trump’s example, leaders have co-opted social media platforms such as Twitter to communicate key political issues. In fact, President Trump is said to have ‘marvelled’ at the instant effect his China-related tweet had on stock prices in May of this year. Such is the impact of these tweets that Bloomberg, the financial news and information provider, now tracks all of his market-related tweets.

The rise of populism

The market’s preoccupation with populism in recent years has superseded the influence of military conflicts and oil supply shocks which tended to dominate geopolitical concerns in the past.

Populism can be defined as an, often anti-establishment, ideology that appeals to ordinary citizens by prioritising national over international interests; and populist movements can prove particularly divisive for countries.

Populist political victories have been equally common in developed markets and emerging markets since the GFC, with notable wins in Hungary (2010), Greece (2015), the UK (Brexit referendum in 2016), the US (2016), Italy (2018), Mexico (2018) and Brazil (2018). In the months ahead, the UK will again be confronted with the populist-led challenge of a possible hard Brexit, while Italy faces the potential of early elections, and populist politics in the US and Argentina ramp up for the forthcoming Presidential /Congressional elections.

Populism has two sides when it comes to the impact on markets… both good and bad. The bad can come in the form of rampant nationalism and protectionism unsettling markets and leading to greater volatility. The trade war between the US and China and the UK’s vote to leave the European Union (EU) are both recent examples of how populism and protectionist policies have weighed on markets. The prospect of the UK leaving the EU without a deal has also led to sterling falling sharply against the US dollar and the euro. On the flip side, fiscal easing in the form of tax cuts and (moderate) spending increases that support supply and demand, are measures that are typically welcomed by financial markets.

Cyber risks

Cybercrime is also an issue that has evolved rapidly from a company-specific one into a geopolitical one. For companies, cybercrime has been on the rise, with 2018 delivering a new high in records exposed via data breaches. Beyond the reputational risk for individuals and companies, the greater risk is that a cyberattack causes broader economic and financial disruption. For sovereigns, allegations of state-sponsored cyberattacks have been tied to election interference and have also been elements of Middle Eastern conflicts and US conflicts with China, Russia and North Korea – with markets reacting to subsequent US sanctions. Recent examples of ‘nation-states’ engaging in cyber warfare include attacks on US energy infrastructure by Russia and Sony Entertainment by North Korea. The US government also banned domestic corporations from sharing technology with Chinese firm Huawei, amid continued concerns about intellectual property theft and malicious cyber activity.

Whilst the nature of geopolitical risks and influences are evolving, what remains certain is that these risks will not be going away anytime soon and they will continue to influence the direction of asset prices, at least over shorter time periods. They can be highly-emotive issues for investors, affecting sentiment and causing volatility in markets – particularly in more economically-sensitive assets and industries like energy and other commodities, as well as foreign exchange markets.

However, although market sentiment can be adversely impacted over the short term, longer term it is more important for investors to look at company fundamentals, and focus on firms with resilient business models that can navigate through the near-term uncertainty.

Whilst geopolitical risks can be unnerving for investors, they can also throw up some interesting opportunities for those willing to look through the volatility!

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.