Geopolitical risk and global markets

In today’s environment, hardly a week passes without a slew of headlines covering the impacts of geopolitical risk on global markets. Here’s a sampling from today, as tensions over Syria ratcheted higher:

  • “Gold scores back-to-back bounce, buoyed by geopolitical tensions” – MarketWatch
  • “Global stocks and oil up, but U.S. dollar slips amid ongoing geopolitical risk” – Reuters
  • “Oil jumps more than 2% on geopolitical concerns” – Financial Times

Ray Dalio, Co-Chief Investment Officer and Co-Chairman of Bridgewater Associates, also chimed in, writing a LinkedIn article about geopolitical developments.

It’s intuitive to say that geopolitical situations can weigh heavily on the markets and are worthy of investors’ worry—but what do we really know about the interaction between geopolitical risks, the macroeconomic environment, and financial cycles?

I came across a recent paper—part of the Federal Reserve’s International Finance and Discussion Papers series—that shines an empirical light on these questions. Titled “Measuring Geopolitical Risk”, the paper is authored by two highly-credentialed Fed economists, Dario Caldara and Matteo Iacoviello, who created a Geopolitical Risk (GPR) index based automated text-search results of 11 national and international newspapers.


The paper’s major takeaways are worth considering—here’s what stood out to me:

What exactly is geopolitical risk?

The authors define it as such:

We follow one common usage of the term “geopolitics,” and refer to it as the practice of states and organizations to control and compete for territory. In particular, we want to identify geopolitical events in which power struggles over territories cannot be resolved peacefully. Accordingly, we define geopolitical risk as the risk associated with wars, terrorist acts, and tensions between states that affect the normal and peaceful course of international relations. Geopolitical risk captures both the risk that these events materialize, and the new risks associated with an escalation of existing events.

By this definition, we are certainly facing multiple current geopolitical risks, including tensions on the Korean Peninsula and fighting in Syria. We can also count the US-China trade war and drama surrounding the poisoning of a former Russian agent and his daughter in the UK, given both are affecting the normal and peaceful course of international relations.

What are the effects of geopolitical risk?

Looking at the US, here’s what happens when a “shock” pushes up the GPR index:

  • The Economic Policy Uncertainty (EPU) index sees a small and short-lived increase, while consumer sentiment sees a small and short-lived decline.
  • Industrial production declines quickly, bottoming out at -0.9% after roughly 6 months before reverting back to trend.
  • Labor market conditions experience a substantial but more gradual deterioration, with payroll employment reaching a trough of -0.4% one year after the shock.
  • Gross trade drops as US imports and exports fall nearly 2% relative to the baseline.

And here’s what happens to the US financial markets in response to a shock:

  • Stock prices drop by almost 3% on impact and remain below baseline for a little over 3 months. Of note, various industries respond differently: The defense industry records a positive but short-lived excess return, while industries that are exposed to the overall economy display somewhat negative persistent returns.
  • Oil prices decrease, bottoming out at 7% below baseline after 3 months. Of note: This is contrary to the conventional view that higher geopolitical risk drives up oil prices.
  • Yield on the 2-year Treasury declines about 20 basis points, indicating a worsening macro outlook and looser monetary policy.

Is uncertainty the true enemy?

The index also teases apart geopolitical threats and geopolitical acts. It turns out that increased measures of “threat” induce large and protracted recessionary effects and declines in stock prices. On the other hand, increased measures of “acts” lead to small but short-lived declines in economic activity and trade, with stocks rising sharply one month later.

In other words, the most damaging adverse effects are sparked by heightened threats of geopolitical events, rather than the actual realization of events. Uncertainty looks to be the driving factor.

Major market players also measure geopolitical risk—though perhaps not very well

Many companies publish indicators of geopolitical risk and uncertainty, including BlackRock, Marsh and Aon. The Fed authors, however, believe most of these indicators aren’t very helpful because of their unclear methodologies. Many indicators don’t state what they are measuring or how they define geopolitical risk, and fail to make the data publicly available, which makes it difficult for users to correctly analyze the indicators and for researchers to replicate and validate the indicators.

If you’re interested in tracking an audited, transparent indicator of geopolitical risk, you’re in luck: The authors make their monthly data available for download. Preliminary data for March 2018 (reflecting data from searches through March 12th) shows the index at a level of 144. For context, that’s roughly the same level seen in March 2014 when Russia annexed Crimea (149) but below the level seen after the November 2015 Paris terrorist attacks (246).

Source: Caldara, Dario and Matteo Iacoviello, “Measuring Geopolitical Risk,” working paper, Board of Governors of the Federal Reserve Board, January 2018