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The impact of Geopolitical risk on financial markets

Blog Blog Details
  • October 08, 2021
  • Raghav Avasthi|
  • Passive Funds
The term geopolitical risk can be broadly de?ned as the risk associated with political turmoil, military conflict, inter-country diplomatic tensions, and acts of terrorism. Over the last ten years, investors have been exposed to several major geopolitical events like Brexit, the US-China trade war, and the Covid-19 pandemic. With the frequency of such events increasing, investors remain cautious of the impact of geopolitical fallout on their investments.

How stock markets perform during geopolitical events

To understand the impact of geopolitical events on the performance of ?nancial markets, we have used the Geopolitical Risk (GPR) index [1] as an indicator of geopolitical risk. The index counts the occurrence of words related to geopolitical tensions in 11 leading international newspapers and signi?es the intensity of GPR. The last ten years saw eight major geopolitical events, starting with the annexation of Crimea in 2014 to the Covid-19 pandemic in early 2020. To understand how stock markets around the world reacted to these events, we picked two country-speci?c indices and two diversi?ed indices. All four were converted to USD to negate any currency fluctuations.


Source/Disclaimer: https://www.policyuncertainty.com/gpr.html, niftyindices, MOAMC, Bloomberg, MSCI. Data as of 31-Jan-2011 to 31-Jul-2021. Performance results may have many inherent limitations and no representation is being made that any investor will, or is likely to achieve the performance similar to that shown. Past performance may or may not be sustained in future.
 
We can see that both diversi?ed stock market indices (S&P 500 and MSCI EM Top 100 Select) have remained relatively unscathed from most of these geopolitical events. However, the country-speci?c indices (Nifty 500 and MSCI China) have been more volatile, showing stronger reactions to negative (and positive) events. The table below summarises the performance (in absolute returns) of these four indices during each geopolitical event.

Exhibit 2 – Index performance (absolute returns) during respective geopolitical event


Source/Disclaimer: https://www.policyuncertainty.com/gpr.html, niftyindices, MOAMC, Bloomberg, MSCI. Data as of 31-Jan-2011 to 31-Jul-2021. Heat-map is created across the 4 indices and all 8 geopolitical events together. Performance results may have many inherent limitations and no representation is being made that any investor will, or is likely to achieve the performance similar to that shown. Past performance may or may not be sustained in future.

The performance of stock market indices varied a lot during the US-China trade war in 2018. The S&P 500 TRI (USD) delivered 12.3% returns while the MSCI China TRI (USD) dropped 10.9%, highlighting the relevance of country-speci?c risk during geopolitical turmoil. On the other hand, MSCI China TRI (USD) was the best performing index of the four during the Covid-19 pandemic, declining just 3.9% during the initial phase of the outbreak.

Transitory nature of geopolitical risk


Source/Disclaimer: Analysis by State Street Global Advisors. Data as of August-2018. Performance of four EM markets – India, Israel, South Korea, and Turkey considered. Past performance may or may not be sustained in future.

The graph above compares the performance of MSCI local indices of four emerging markets – India, Israel, South Korea, and Turkey through 71 geopolitical events from 1980 – 2018. It clearly shows that any effects of geopolitical events on stock markets, whether considered positive or negative, are short-lived and transitory. The markets seem to "shrug off" the impact quickly as information spreads and rationality takes over. A year later, things are virtually back to historical averages. Though geopolitical risk remains a legitimate threat for investors in the short term, expanding the time horizon of your investment can help tide over such volatility.

An internal analysis of 1 and 3-year performance (CAGR) of stock market indices post respective 8 major geopolitical events indicate similar results (see annexures).
 
Dealing with Geopolitical risk

Despite the transitory nature of geopolitical risk, its effects can be signi?cant for investors with a shorter investment horizon and lower levels of international diversi?cation. Therefore, investors should –

1.Diversify their portfolios across several countries equity markets. As of 30-Jun-2021, ~40% of the revenue of S&P 500 constituents was from foreign countries, greatly reducing country-speci?c risk. Similarly, the MSCI EM Top 100 Select index comprises the top 100 companies from 7 emerging markets like China, Taiwan, and South Korea.

2.Invest for the long-term and not worry about short-term volatility. The impact of geopolitical risks on the performance of stock markets is transitory, and they normalise over time.

References –

1.Caldara, Dario and Matteo Iacoviello (2018). Measuring Geopolitical Risk. International Finance Discussion Papers 1222. https://doi.org/10.17016/IFDP.2018.1222

2.“How Does Geopolitics Affect Financial Markets?” – State Street Global Advisors, 2018.

3.Geopolitical Risk Index values – https://www.policyuncertainty.com/gpr.html

Annexures –

Annexure 1 – Index performance (CAGR) 1 year after respective geopolitical event


Source/Disclaimer: https://www.policyuncertainty.com/gpr.html, niftyindices, MOAMC, Bloomberg, MSCI. Data as of 31-Jan-2011 to 31-Jul-2021. Heat-map is created across the 4 indices and all 8 geopolitical events together. *1 year rolling average is calculated for the entire period 31-Jan-2011 to 31-Jul-2021 and captures forward as well as historical performance. Performance results may have many inherent limitations and no representation is being made that any investor will, or is likely to achieve the performance similar to that shown. Past performance may or may not be sustained in future.

Annexure 2 – Index performance (CAGR) 3 years after respective geopolitical event



Source/Disclaimer: https://www.policyuncertainty.com/gpr.html, niftyindices, MOAMC, Bloomberg, MSCI. Data as of 31-Jan-2011 to 31-Jul-2021. Heat-map is created across the 4 indices and all 8 geopolitical events together. *3 year rolling average is calculated for the entire period 31-Jan-2011 to 31-Jul-2021 and captures forward as well as historical performance. Performance results may have many inherent limitations and no representation is being made that any investor will, or is likely to achieve the performance similar to that shown. Past performance may or may not be sustained in future.

Disclaimer and Risk

This article has been issued on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this document is for general purposes only and not a complete disclosure of every material fact. The indices mentioned herein is for explaining the concept and shall not be construed as an investment advice to any party. The information / data herein alone is not suf?cient and should not be used for the development or implementation of any investment strategy. It should not be construed as an investment advice to any party. All opinions, ?gures, estimates and data included in this article are as on date. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. The statements contained herein may include statements of future expectations and other forward-looking statements that are based on our current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Readers shall be fully responsible/liable for any decision taken on the basis of this article. Mutual Fund investments are subject to market risks, read all scheme

Investments in securities markets are subject to market risks, read all the relevant documents carefully.
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