Geopolitical Risk

Geopolitical Risk: Meaning, Impact on Markets, and Past Examples

Geopolitical risk refers to the risks that arise from geographical relationships or various factors that exacerbate political, military, and social tensions, which in turn affect the global economy.

This article explains the meaning of geopolitical risk, its relationship with markets, quantitative data, and past examples.

What is Geopolitical Risk?

Geopolitical risk refers to the uncertainty caused by political and military tensions, such as conflicts or terrorism, in specific regions, which can impact the economies of related countries or the global economy.

Recently (as of 2024), the situation in Ukraine and the Middle East, including Israel, are examples of geopolitical risks.

In financial markets such as the foreign exchange market, the impact of geopolitical risk is usually short-term. However, if the situation seriously affects the economies of major countries or persists for a long period, it can have a significant impact on investment strategies. Therefore, it is crucial to stay updated with the latest information.

Defining geopolitical risk clearly is not easy, and different studies provide different definitions. For clarity, we will categorize geopolitical risk into two types:

Geographical Risk Political Risk

What is Geographical Risk?

A country’s geographical position significantly affects its relationships with other nations.

Border disputes or geographical characteristics of neighboring countries can lead to tensions or conflicts, which is undeniable.

In addition, natural disaster risks are closely related to geographical conditions. Earthquakes, floods, typhoons, and other natural disasters tend to occur more frequently in certain areas.

Apart from risks like border conflicts, natural disaster risks can also be considered as geographical risks.

What is Political Risk?

In countries with lower government stability, not only is there a possibility of policy changes, but social unrest and instability are more likely to occur. Political turmoil can severely impact investments and business activities.

Additionally, conflicts and terrorism are also included in political risk.

Political risk is broad and encompasses everything from government policy changes to conflicts and terrorism.

Quantifying Geopolitical Risk

There are several ways to quantify vague geopolitical risks and convert them into quantitative data.

Composite Index of National Capability (CINC)

This is a measure of national power created by J. David Singer in 1963 for the War-Related Project. It uses the average percentage of world totals in six different elements: national population ratio, urban population ratio, steel production ratio, energy consumption ratio, military expenditure ratio, and military personnel ratio.

Militarized Interstate Dispute (MID)

This dataset records military conflicts between countries. It tracks disputes that do not involve full-scale wars but include any conflicts where one or more countries threaten, demonstrate, or actually use military force against another country or countries. The intensity ranges from force threats to actual combat (non-war).

Geopolitical Risk Index (GPR)

Developed by Dario Caldera and Matteo Iacoviello in 2018, this index measures the proportion of articles related to geopolitical risk search terms in 11 major U.S. newspapers. Geopolitical risk terms include:

1.War Threats
2.Peace Threats
3.Military Buildups
4.Nuclear Threats
5.Terror Threats
6.Beginning of War
7.Escalation of War
8.Terror Acts

Geopolitical Risk and Its Relationship with Markets

Let’s explore the relationship between geopolitical risk and markets from the following perspectives:

·Geopolitical Risk and Gold Prices ·Geopolitical Risk and Oil Prices ·Geopolitical Risk and Bond Prices ·Geopolitical Risk and Stock Prices ·Geopolitical Risk and Exchange Rates

Geopolitical Risk and Gold Prices

Gold has historically been considered a highly valuable metal and was once part of the gold standard. It is regarded as a financial commodity.

Gold doesn’t provide returns such as interest or dividends when held. Therefore, under normal conditions, investors are not particularly eager to invest in gold.

However, once geopolitical risks like wars emerge, gold, as a tangible asset, is often bought, and its price tends to rise.

Geopolitical Risk and Oil Prices

Like gold, oil also has a financial commodity aspect, but it is more prominently a strategic resource.

When oil-producing countries and their surrounding regions face geopolitical risks like war, concerns about a decline in oil production capacity often lead to an increase in oil prices.

Geopolitical Risk and Bond Prices

When geopolitical risks materialize, bonds from affected countries or regions are often sold off by risk-averse investors, leading to a decline in bond prices and an increase in yields.

On the other hand, bonds from countries unaffected by geopolitical risks tend to be bought, as investors seek safer options.

Geopolitical Risk and Stock Prices

Once geopolitical risks like wars manifest, they can adversely affect the global economy. Even countries not directly involved can feel the effects, such as oil price increases.

Especially during major geopolitical events like wars, global stock prices often decline.

Geopolitical Risk and Exchange Rates

The movement of the U.S. dollar is a key point when geopolitical risks emerge.

In cases of moderate risks like regional conflicts, currencies from emerging markets tend to be sold off, while the U.S. dollar is bought.

On the other hand, if terrorist attacks targeting the U.S. occur, the dollar is sold off, and safe-haven currencies like the Swiss franc are bought.

Examples of Geopolitical Risk Impacting Markets

Here are two examples illustrating the impact of geopolitical risks on the markets:

1.Russia’s Invasion of Ukraine

2.The Spread of COVID-19

Russia’s Invasion of Ukraine

In February 2022, Russia began a military invasion of Ukraine, and as of April 2024, the war is still ongoing.

The most impacted markets have been commodity markets, especially oil.

Oil prices (USOIL) surged significantly. In February before the invasion, prices were around $90, but by March, they reached nearly $130 (see the WTI oil price chart below).

Additionally, as Ukraine is a major wheat exporter, the anticipated decline in wheat production led to a spike in wheat prices.

Both oil and wheat prices fell back to pre-invasion levels about six months later, but the invasion triggered a surge in commodity prices, contributing to global inflation.

The Spread of COVID-19

In early 2020, the COVID-19 virus spread globally, leading many countries to implement lockdown measures.

As countries and the global economy were expected to slow sharply, corporate profits were negatively impacted, and stock markets fell, a phenomenon known as the "COVID-19 Shock."

Central banks acted swiftly to implement expansionary monetary policies to prevent economic collapse. As a result, global stock markets bottomed out around mid-March (see the S&P 500 chart below).

Afterward, with the recovery of the economy and the push from monetary easing policies, global stock markets saw a significant rally.

Summary: Geopolitical Risk | Meaning, Market Impact, and Past Examples

Geopolitical risk is vast and its impacts are broad, with definitions often being unclear.

When understanding geopolitical risk, it's important not only to identify what events are occurring but also to assess which financial products are being impacted.

When geopolitical risks arise, it is essential to stay informed and closely monitor financial markets to understand which assets are most affected.