Market attention to geopolitical risks has reached its highest point since 2005. Recent years have seen a populist, anti-establishment surge across the western democracies, a reemergence of great power rivalries, and intensifying global trade disputes. The number of volatile geopolitical situations is at one of its highest points since the end of World War II.
Such geopolitical events can have meaningful effects on the global economy, financial markets and investment portfolios. In fact, we see geopolitical risk as a material market factor in 2019—and we’re paying close attention to key potential flash-points in the coming months. See a list of events in our new geopolitical calendar.
To be sure, macroeconomic fundamentals such as economic growth and corporate earnings are typically the major drivers of financial market returns, especially over longer investment horizons. Yet idiosyncratic risks, including those triggered by geopolitical events, can have an out-sized impact on markets and individual securities when they occur.
Defining geopolitical shocks
We define geopolitical shocks as wars, terrorist acts, and other events that increase tensions between states and affect the normal course of domestic politics and international relations. Such shocks can impact economies and markets in myriad ways. Trade tensions, for example, can lead to the imposition of tariffs that disrupt global supply chains and the flow of commerce. Wars can lead to oil price shocks that boost inflation and hurt consumer spending. And sudden shocks such as terror attacks can hurt market confidence, prompting capital flows out of risk assets and into perceived safe havens.
We recently performed a historical analysis of asset price reactions to 68 key geopolitical risk events since 1962. Our analysis shows the average market response to unexpected geopolitical shocks has historically been relatively modest and short-lived. Equity prices tend to take a hit and bonds rally in the immediate aftermath, but these moves often dissipate quickly. Example: The S&P 500 Index fell almost 12% in the first week of trading after the 9/11 attacks of 2001. Yet the stock market had recouped all of these losses by 25 business days after the event.
We find the negative market reaction has historically been more severe if multiple shocks occur simultaneously or if the economic environment is weak to begin with. Equity market losses tended to be of greater magnitude in periods when the economy was contracting.
This is one reason why we see geopolitical risk as a material market factor in 2019 and beyond, against a backdrop of slowing growth and elevated uncertainty about the economic and corporate earnings outlook.
Our top-10 geopolitical risks
We assess the top-10 geopolitical risks we see posing a threat to markets and the global economy in our Geopolitical risk dashboard. There, our BlackRock Geopolitical Risk Indicators (BGRIs) for each risk can help assess to what extent the geopolitical risks are priced in. The BGRIs measure the degree of market attention to specific risks relative to their history. The higher the BGRI level, the more we assume that risk is priced in. We use this insight to adjust our estimated market shocks for each risk according to its BGRI—and to pinpoint assets especially sensitive to the risk.
Our efforts to analyze and price geopolitical risks are a work in progress. They are based on our effort to better measure and monitor geopolitical risks and their market impact in a systematic way. Our approach—which underpins our Geopolitical risk dashboard — marries qualitative and macroeconomic analysis with large-scale portfolio analytics and “big data” text mining. You can read more on our framework — and the early conclusions of this ongoing work—in our recent Global insights piece Gauging geopolitics: A framework to assess and price geopolitical risks.
Thomas E. Donilon is Chairman of the BlackRock Investment Institute and a contributor to the blog.
Catherine Kress, Advisor to the Chairman of the BlackRock Investment Institute and a contributor to the BII’s geopolitical views, contributed to this post.