Geopolitical risk has returned as a key factor influencing investment risk and return, with several recent surveys naming it one of the most important concerns for institutional investors.[1] Yet, many investors lack a framework for systematically measuring and managing these exposures and risks in their portfolios. We have attempted to address this gap by considering how to define and quantify geopolitical risk and exploring alternative measurement approaches. We also compared market, sector and factor returns in periods of high and low geopolitical risk.
Defining geopolitical risk
Geopolitical risk has been somewhat loosely and imprecisely defined as being the additional challenges and opportunities associated with investing in foreign markets, particularly from a U.S. investor's perspective.[2] This definition is limited, however, because it overlooks economic exposures. Even a domestic portfolio can be significantly affected by geopolitical changes.
A more-comprehensive definition, introduced by Dario Caldara and Matteo Iacoviello, describes geopolitical risk as the threat, realization and escalation of adverse events such as wars, terrorism and political tensions that disrupt international relations.[3] Besides broadening the concept of geopolitical risk, this definition recognizes that both the threat and the realization of risks can influence investment decisions, market dynamics and global macrofinancial cycles.
Getting a measure of geopolitical risk
Academics have proposed various methods to measure geopolitical risk. These approaches include measuring the frequency of articles discussing adverse geopolitical events in leading newspapers, based on a defined list of keywords (Geopolitical Risk Index, or GPR);[4] examining the correlation of squared standardized residuals across a wide range of assets, indicating a common volatility factor;[5] and counting the frequency of the word "uncertainty" and its variants in the Economist Intelligence Unit country reports (World Uncertainty Indicator, or WUI).[6] Compared to the other two measures, the WUI captures a wider range of uncertainties, including economic and political developments across a large set of countries using a consistent methodology.
For this blog post, we used a blended indicator formed from the GPR and the WUI because they offer complementary measures of geopolitical risk and uncertainty.[7]
Trends and spikes tell different stories
Markets have often reacted as adversely to the threat of geopolitical events — such as wars and terrorism — as to their actual occurrence. While major geopolitical events can cause spikes in market-risk measures, their medium-term impact on financial markets has often been limited, meaning that geopolitical risk is not equivalent to a few “black swan” events.
A rising trend, however, typically indicates increasing and more long-lasting periods of geopolitical uncertainty, which may prompt companies to adjust operations, such as restructuring supply chains, and could also influence investor behavior as well as asset prices in anticipation of these adaptations.
Geopolitical risk has been at historically high levels in recent months
Measures of geopolitical risk vs. market-based measures of uncertainty
Do measures of geopolitical risk provide additional constructive information versus more conventional market-based gauges of uncertainty, such as the Cboe Volatility Index® (VIX® Index)?
The GUI and the VIX Index are largely independent of each other.[8] Although they have occasionally risen together, for example, after 9/11 and the Russia-Ukraine war, they have mostly varied independently. The GUI has generally remained stable during economic and financial crises since the mid-1990s, whereas the VIX Index has been largely unaffected by terrorist events, except for 9/11.
Geopolitical and market risk have spiked at different times
Moreover, when we segment the months by when either or both the VIX Index and the GUI were higher than their long-term averages, we see that months when both were elevated had the lowest-average equity-market returns. Sector returns during such months also showed that these were periods with a pronounced cyclical-versus-defensives return spread.[9]
Geopolitical risk measures have been additive to conventional measures of uncertainty
Degree of geopolitical risk has impacted returns
Equities can vary in sensitivity to geopolitical risk at broad market, sector, factor, country and asset levels. We explored the market, sector and factor variations by comparing returns in periods of high geopolitical risk versus periods in which such risk was low.
High geopolitical risk associated with lower equity returns and higher forecast volatilities
Industries, such as defense, shipping and oil and gas, as well as firms with significant international operations, especially in politically unstable regions, might be more exposed to geopolitical risk. Conversely, firms with typically localized operations and less reliance on global supply chains, such as those in health care and utilities, may have lower exposure to geopolitical risk.
Active sector and factor returns varied with geopolitical risk level
Building more-resilient portfolios
We have shown that geopolitical risk has significantly impacted global equity markets. High geopolitical risk was associated with lower equity returns and higher forecast volatilities. We found that measures of geopolitical risk provided added information beyond conventional measures of uncertainty, such as the VIX Index.
The average returns of factors and sectors varied with the level of geopolitical risk. The energy, materials and consumer-services sectors showed the greatest variation in their reactions to high and low geopolitical risk regimes. Conversely, sectors such as health care and utilities, appeared to have lower exposure to geopolitical risks, as evidenced by weaker reactions to level changes.
With these findings in mind, we continue to explore how geopolitical risk measures can be further integrated into MSCI’s factor models and indexes.