The focus on the Eurasian continent

 

Hal Brands provides s history of the geopolitics associated with the Eurasian continent over the last 100 years. While the history was interesting and a quick read, it centered more the European politics during the 20th century and now the switch to a focus on China. It did not spend much time on the development of the Russian empire which has always focused on trying to dominate the Eurasian continent. 

Now it is China who is trying to dominate this land mass. To some degree the US is a digression to this long struggle and core Europe is also a marginal player in these geopolitical dynamics. 

This is a Russia-China story first and world politics story second. In an effort to protect its western border, Russia has made a pact with China, yet solving one problem will create a new problem on its eastern reaches. There is a new partner mix between Russia and China that will define the next decade of the 21st century. 

Unfortunately, most analysts do not seem to be overly concerned about this changing balance which will impact the supply of key natural resources. Brand provides a nice recap of Eurasian politics, but it does not stretch the imagination of what is and what will be. 

The different presidential ages and finance

 

Monday starts Trump 2.0. Many are expecting a new regime or world order. Certainly, there are clear signals of significant change. Many are thinking this will be an extension of Trump 1.0. Still others just want to return to some bygone era that did not exist. Most investors do not want to see big upheaval in policies and prefer slow transitions. 

I don't want to provide an exhaustive description of different regimes but open a discussion on different time periods based on presidents. Unfortunately, many presidencies are not determined by the personality of the man but by the events that are faced. In fact, every presidential regime is clouded or burdened by some singular economic event. Interestingly, most look at presidential periods based on a cultural lens and not a policy perspective. These comments to describe the periods are focused on economic events.

Reagan- Bush - The change away from big government that did not occur; currency upheaval, interest rate upheaval and then decline, stock increase, stock market crash and thrift crisis. 

Clinton - the peace dividend, The Great Moderation, but also the EMS crisis, Mexican debt crisis, Asian and LTCM crisis, end of deficits. a Democrat extension of the Reagan-Bush period

Bush-Obama - The great pivot to Middle East tensions and the end of the peace dividend and singular US hegemony; the Great Financial Crisis and the new era of QE. 

Trump-Biden - Period of adjust and rethinking impacted by the singular event of the Pandemic. The move to a bipolar world with a breakdown of global organization. 

Trump 2.0 - The new world of trade and further erosion of the great period of globalization. the furthering of a bipolar world.  

The world of polar regimes impacts capital flows

 

When describing global power politics across nations and regions, most analysts like to keep it simple. The world is often divided into a bipolar world of great powers. There are periods of transition and change, but the general view is that there are dynamics between two great economic systems and the rest of the world aligns itself across this great divide. 

In the post-WWII period until 1990, we lived in a bipolar world between the US and the Soviet Union. The period post the end of the Soviet Union turned into a single polar world for the US only to see a new bipolar world between the US and China. There is no single date when there are switches in polarity, but these regime shifts impact investment strategies. The unipolar world was the period of great globalization and now we are seeing a change in trade flows and globalization as countries adjust and realign to the different spheres of power. While this may not be an immediate trade, it does represent shifts that will impact all markets. 

Commodity flows will be become more strategic as countries determine how to source raw materials from friendly areas. This is clearly seen in the energy trade flows and the sourcing of rare minerals. Capital flows will change with lower direct investment across poles. The capital flow changes will occur for both equities and bonds as money avoids China and looks for other emerging markets. These shifts will increase in 2025 as alignments, tariff, and sourcing changes continue.

Disorder - Hard Times in he 21st century - Expansive read on current times

 

Helen Thompson, a professor of political economy at Cambridge, has written an expansive book, Disorder: Hard Times in the 21st Century, on the current disorder around the world through three histories. She looks at the geopolitics of the last century, the world economy, and the changes in western democracies. All are in disruption and face uncertainty. All are integrated and lead to a single story. Interestingly, all are tied to the economics of oil.

This is a dense book with an expansive vision of the world order. Do not expect this to be a fast read, but the result is a deeper understanding of how the world is connected. 

Why is this critical for macro investors? The reason is simple, global uncertainty will lead to market disruptions. You need to know the drivers of disruptions. Why is this critical for quant investors? Regimes change and model sensitivities will change with regime switches. If you are not aware of the global disorder, you will be subject to forecast biases and losses. 

Multipolar world and investing money - ambiguity drives down correlations

The key issue for international investing over the long run is whether the world is a single pole, bipolar, or multipolar set of interests and country alignment. Clearly, we moved from a bipolar world after the collapse of the Soviet Union to something closer to a singular pole. Some will say that we have a new bipolar world between the US and China, but the close interconnection between these two countries makes it hard to argue from a trade perspective regardless of rhetoric. Nevertheless, a bipolar world seems more likely as Russia and China have moved closer through trade and politics There is also a strong view that the world has turned multipolar with a broader set of competing interests across a diverse set of countries. 

Is India in a single center of interest or is it something unique? Is the Middle East in two centers of influence or is it more ambiguous? Is Latin America a separate sphere of influence? The world is more complex and less clear-cut in 2023 than 1993 or 2013. 

Trade lines especially with emerging markets are moving closer to a China-Asia focus than an US-EU focus. Financial flows are still dominated by the dollar, but these capital flows have been disrupted by political drama through growing sanctions. Countries want to become less dollar dependent even though it may be harder to do in practice because being on the wrong side of US policy can be harmful.

While we may not have insight on the changing tectonic shifts in geopolitics, we can say with certainty that the higher ambiguity of political relationships will place downward pressure on correlations across countries. A multipolar world will also create greater shock risk from alignment adjustments. EM risk higher in a multipolar world. 

Reputation, cancel business, and sanctions

Even before sanctions, firms have been exiting their businesses in Russia. Importers have self-sanctioned and reduced exposures. Banks have stopped financing Russian trade. Some of these actions were under the expectation of sanction, but it also has been an attempt to maintain reputation. Especially in a cancel culture environment, it makes perfect sense to act first before shareholders and customers question or protest you lack of response. 

Reputations has real effect on stock prices and risk premia. A declining reputation will cause investor exits and thus needs to be managed. Reputation can come in several forms:

• Marketing - Branding - Better perceived products will command premium pricing. 
• Regulatory - fines, penalties, and lawsuits - A more reputation from regulatory issues will be costly.
• Quality - Poor quality and service will destroy firm value. 

Notice that choosing who to source for firm inputs and have as customers is not usually thought of as foundational to branding, yet it is now critical. In the case of Russia, this type of branding has been front and center in the news. The size of Russia's raw material exports coupled with their active aggression on another country makes this reputation issue too hard to ignore. 

Below we show a simple framework for categorizing at reputational risk. It can take the form of a reputation-reality gap, changing beliefs, and poor internal coordination. A loss of reputation is hard to regain and can have lasting damage. Reputation cannot be seen in the accounting numbers; however, a decline in reputation capital is measurable with share prices as investors cancel those perceived as engaging in questionable practices.  

From HBS article "Reputation and Its Risks"

The New Globalization "Dark Ages"

 

We have entered the new "Globalization Dark Ages". Global trade is not done, but the golden age of globe trade is no more. It may have end pre-COVID. It was on the ropes during COVID. The globalization end has come through global sanctions and not COVID restrictions. 

We should see a reversal in trade growth because the foundations of globalization have been destroyed. Sanctions of goods and finance are now a serious global tool of economic warfare that affects all countries, producers and consumers, exporters and importers. In a sanctions world, there is no free trade just allowed and not allowed trade. Free trade is now determined by government policy.

Cancel and isolation are the new means of global warfare. Trade war has been taken to a new level. We are not saying that these actions are unjustified, but the implications are profound and will not be reversed with a flip of a switch. Can we really expect trade and direct investment will return soon if the war in Ukraine ends tomorrow?

Multilateral trade driven by the rules and norms of WTO is no more. Companies are pulling back from global aspirations even without being told by governments to stop dealing with some bad actor countries. Trade is moving from multilateralism to bilateralism as sides are chosen. 

Global financing of trade and foreign direct investment is not just in peril but has swiftly ended. There are no safe assets given a world of electronic money transfer isolation. 

We are moving from low mercantilism to strategic country production as a protection against trade autarky and isolationism. National interests are served by isolation. There is a new Iron Curtain based on a wall of trade and finance limitations. Instead of keeping labor in, the curtain is keeping goods and capital out. Trade shunning.

The triumph of a multinational corporate model has ended and is reverting to a model of corporations serving the interest of states. There is no reason for multinationals to be everywhere if the threat of sanctions are real. The political threats are not just from the host country restricting behavior but the home country stopping corporate action.

Supply chain logistics focused on global cost efficiency will be replaced with supply chains based on national threats and the avoidance of sanction risks. Alternative sourcing is now a critical strategy. 

The source of fungible commodities is now relevant. Oil is not oil. It is biased by being Russian oil. Wheat is not wheat but Russian wheat. Sanctions against commodities coming in and export restrictions on goods coming out of a country.

Every country will be an island or at best part of archipelago of countries not based on a region but on politics. Empires and commonwealths of similar interest will replace free trade. There will be a new equity risk premium associated with sanction risks. Investors will need a premium for multi-national firms. 

Ice-nine - sanctions and the international payments system

Ice-nine is the fictional material appearing in Kurt Vonnegut's novel Cat's Cradle. Ice-nine is supposedly a polymorph of water more stable than common ice; instead of melting at 0 °C, it melts at 45.8 °C. When ice-nine comes into contact with liquid water below 45.8 °C, it acts as a seed crystal and causes the solidification of the entire body of water, which quickly crystallizes as more ice-nine. 

Restrictions in the international payments system and sanctions can have the characteristics of ice-nine. Assets and institutions that are sanctioned can freeze up the financial system because everything that it touches may turn into a frozen asset. If you hold Russian assets or currency and it cannot be transferred or uses as collateral, other assets will freeze or become illiquid. Banks, funds, or indices that hold or have Russian assets are impaired. If the Russian central bank cannot employ its assets, liquidity is frozen across Russia. 

The situation will get worse if energy payments are included in sanctions. We are already having the situation that Western countries do not want to buy Russian energy products. Oil is selling at deep discounts and there are limited buyers for refined products. 

So why hasn't the ice-nine effect fully kicked in? A close look is that there is a difference between sanction and bank restriction announcements and reality. There have been delays in implementations and carve-outs that reduce the financial freeze and allow banks and firms to get prepared for the freeze; nevertheless, it is happening and there are going to be repeats to what was seen during the GTC. Like the Lehman event in 2008, the ripple effect can be much greater than just the size of the obvious assets. Financial ice-nine exists. 

The big systemic risk - the need for stability and order

Government institutions fail when they cannot clearly communicate the realities that surround them. These institutions fail when they do not realize that in a real politic environment - there is always a play for power and a focus on self-interest. Government institutions fail when they don't provide stability and order both for those being governed and across institutions. These institutional failures are the real geopolitical systemic risk which should be the concern for investors. Tail risk events are often the result of institutional failure not the cause.

Systemic risk usually focuses on connectivity, technical details, and specific market failures and not broad failure of governing institutions.  Yet, the stability of the global order provides an environment for other more micro issues to take center stage for investor concerns - which is a good thing. When the global order is disrupted, there will be less investment and.  a flight to safety because the animal spirits of optimism are curtailed. 

Perhaps not so hidden in the pandemic is a turning away from experts and government institutions. Whether on the local, national, or international level, the lack of confidence in the current order will have an impact on financial investments. 

How can rising systemic risk be the case when we just had equity returns (SPY) of close to 27 percent for the year? Fiscal and monetary largess with pent-up demand was able to mask declining confidence, but globally there is less confidence in governments being able to articulate and address crises. The institutional glue that will bind behavior in a crisis has weakened which increases systemic risk. The failure of order at the local level will then play-out across countries. 

Unfortunately, this cannot be easily measured or isolated through some quant model. This is the essence concerning animal spirits and investment confidence. There is no easy measurement of optimism in the face of uncertainty. For Keynes in the 1930's, it was the role of government to prod aggregate demand and get confidence rising. However, if there is less confidence in potential solution providers, the threat of systemic failure increases. Yes, while this is pessimistic, discussing the systemic risk framework is critical for any 2022 predictions. 

Geopolitical risk - Not getting enough attention?

A low value for the BlackRock Geopolitical Risk Index (BGR) suggests that these macro risks are not getting much investor attention. It could be that these risks are just low, or it could be that there is a lack of attention on important global issues. Either way, geopolitics are currently just not important to investors, and that is problematic. 

Geopolitical risks can be isolated to a specific regions or sectors, but more often, it is a common factor that will directly impact market risk. The potential price impact will be stronger if key markets are overvalued. Whether China-US tensions, or new Middle East issues, these will have a common impact that will serve as a valuation catalyst. 

The BGR index has been falling since the change in US administrations, yet the leading geopolitical risks have not changed and policies have not significantly changed. However, perceptions that there is policy clarity in the face of geopolitical risks have fallen. The current ambivalence to geopolitical risks is worrisome and should require action. However, taking risk off the table is never rewarded during the waiting period before a crisis.

 

Geopolitical risks - The spillover to markets is real

 

Geopolitical threats create risk and uncertainty. This seems intuitive and can actually be measured through tracking geopolitical risk indices. These threats can be linked to market reactions, so investors can measure and act on these evolving risks. Below is the widely used Geopolitical threat index developed and updated by Matteo Iacoviello. It uses key word searches from leading newspapers around the world to measures geopolitical threats and acts. In many cases, elevated threats will impact financial markets.

A common theme of my investing thesis has been to focus on the nexus between risk, uncertainty and pricing. If uncertainty increases, it will carry over to market risk as measured by volatility. This increase in market risk will add to market dispersion, change correlations, affect risk aversion and sentiment, and change risk premia. Even if market prices don't move significantly, there will be a change in the wings of return distributions. 

Markets that engage in global trade in sensitive geopolitical area or have been perceived as a place of safety should be more sensitive to changes in these threats. Threats go up and there should be a flight to safety and a movement out of risky assets. 

A causal link from geopolitical threats spillover to oil price volatility and gold moves has been found with recent research. Similarly, threats influence the capital investment decisions of companies. This alternative data index can help with global macro decisions.

See recent research:

“Are geopolitical threats powerful enough to predict global oil

price volatility?” 

Environmental Science and Pollution Research https://doi.org/10.1007/s11356-021-12653-y

“Geopolitical Risk and Corporate Investment” Ruchith Dissanayake, Vikas Mehrotra, and Yanhui Wu

“Hedging geopolitical risk with precious metals” Dirk G.Baur and Lee A.Smales Journal of Banking & Finance Volume 117, August 2020,

“Forecasting realized gold volatility: Is there a role of geopolitical risks” Finance Research Letters Volume 35, July 2020

Animal spirits, declinism, and policy choices that will impact asset allocation

There will be significant work published on what should be the right asset allocation for 2021. I read as many of these pieces as I can get my hands on.  There is a simple question for US investors tied to these forecasts that moves beyond COVID and economic policies. Do you have optimist or pessimist view on US economic and political prospects beyond the COVID recovery?

Given the high level of uncertainty, this question can be phrased differently. Should you have positive animal spirits, as described by Keynes, to invest and spend even in an unknown world, or should you take a defensive posture based on economic weakness and US pessimism? 

Beyond the policy tactics of vaccines and lockdown reversals that will affect market expectations, investment allocations should be based on optimistic or pessimistic animal spirits and what is the process and policy choices that will get the economy to a more positive state. This positive state is tied closely with the broad political view of US declinism and pessimism concerning its preeminent status in the global economy and world affairs. The path for a correction to declinism will drive longer-term US optimism. (See "The China Challenge Can Help America Avert Decline: Why Competition Could Prove Declinists Wrong Again" in Foreign Affairs for a general discussion of declinism.)

  

For Keynes, markets are often driven by animal spirits, the optimism or pessimism that exists when the future is highly uncertainty. When uncertainty is high, the normal tools of valuation and analysis are ineffective. Investors just don't know and have to rely on their feeling of optimism or pessimism. In a depression or recession, pessimistic animal spirits drive decisions. A recovery occurs when sentiment changes to optimism. There is no question there is a current sense of financial optimism; however, this euphoria may not be matched in the real economy. More optimistic animal spirits will drive the US economy beyond catch-up to long-term growth. 

Declinism, the belief that the United States is sliding irreversibly from its preeminent status, has been a major theme of the last four year and will be the key theme for the next four years especially if there is a desire for stronger long-term growth. Declinism talk started much earlier but has swept into the general political discussion in more tangible and extreme forms of political choice.  

The declinism solution is centered between two extremes for policy. One position has been it can be arrested through unilateralism and a reversal of the liberal globalist order. The alternative position also believes declinism is caused by inequality and a lack of global cooperation that needs to be addressed through social and economic restructuring and the rule of international law and cooperation. Both argue for a change in the behavior and structure of the United States; nevertheless,  the choice of direction will impact the longer-term pricing of financial assets and the potential for sustained growth. 

Investor allocations will be making a choice on whether declinism can be reversed and the policy form necessary for the reversal. The success of risk-on asset allocation will be determined by the declinism solution accepted by the public and how that path forward will improve both the US and the global economy. Any end of declinism will be coupled with a sense of optimism that problems can be overcome and that investment will be rewarded and productivity enhanced; however, the policy choices will impact the form and placement of the optimism. Investor should consider alternative declinism solution paths.  

This discussion may be an abstraction, but sustained financial gains needs to be coupled with a robust economy that moves beyond a story of COVID recovery.     

Political Risk Assessment - Big exposures are often under evaluated

Macro investing will focus on global monetary policy and growth and make assessments on relative asset returns, yet there does not always seem to be a structured approach to political risks. A structured approach looks at different types of political risk and then tries to understand the core questions for these risks, analyze the likelihood of these risks, form an action plan of taking exposure or mitigation, and then responding with trades. 

These issues are addressed in the book Political Risk: How Businesses and Organizations Can Anticipate Global Insecurity by Condoleezza Rice and Amy Zegart. While this is a book focused on corporate political risk assessment, it is very relevant for any fund manager. 

The book focuses on a set of political risks and when I review the list, it becomes immediately obvious that it is applicable to any market assessment.  Some of these risks are firm specific and not asset class focused, but it still has clear relevance for macro investing.

The problem with any political risk assessment is that many of these risks have low likelihood of occurring, so it is not easy to price and take advantage of opportunities. Most political risks have the chance of being large tail events given they are hard to price; consequently, it is all the more important to analyze and assess. 

Rice and Zegart focus on a four step process: understand, analyze, mitigate and respond. Understanding political risk starts with assessing a firm's political risk appetite. For example, an investment in Mexican equities or bond is a relative return analysis based on political risk assessment. If you cannot or do not have the skill to take on political risk, then it should be avoided regardless of the potential return. The analysis starts with the information that is available. Is there good information on the risks that can be used for rigorous analysis. Risk mitigation is a function of having a warning system that can alert you of higher risks. The warning system will allow risks to be mitigated and damage limited. Finally, effective risk management will assess responses to threats. Good response determines whether risks were avoided, and opportunities capitalized.

If you are a macro investor, a structured assessment of political risks is essential for good portfolio construction. There is no positive gain from diversification if there are just hidden political risks unassessed. 

Biggest long-term threat in 2020 - Deglobalization

Everyone talks about the economic wall of worry, and the wall seems to be getting taller. Pandemic. Recession. Credit issues. Lockdowns. Nevertheless, these worries will pass. They are cycles, shocks, and bumps. They do not define our global system of trade and benefits. Policy-makers can see the immediate harm and are using their set of policy tools to dampen and reverse the negative effects.

Unfortunately, the longer-term worry that will stick with all economies is our trend to cut connectedness, globalization. This worry does not have a set of voices or policy prescriptions to offer as solutions. There are no current advocates against deglobalization, yet trade and the broader term of globalization has been the key generator for world economic growth. 


The free movement of labor, capital, ideas, goods, and services across time and space has created enhanced economics opportunities for most and explosion of a middle class in emerging markets. These flows have driven global growth in spite of the financial excesses and shocks over the last few decades. 

If the current globalization era ends, all economies will suffer, and no localized or national policy will solve the problem. There is a need for worry because globalization is not something that just happens. It is not inevitable. It takes work. Mercantilism is often viewed as a natural policy when countries think trade is a zero-sum game.

History has shown surges in world economic growth when there has been more freedom of global trade and financial flows. The great globalization surges include the pre-WWI period, the Bretton Woods period, and the China-WTO period. All were associated with national and global structures open to international flows, technology that allowed for low flow costs, and organizations that could coordinate economic activity. 

Globalization has been under assault for some time. Some of the arguments against globalization are relevant, should be heard, and require adaptation, but the fundamental premise of globalization is being questioned. This generalized globalization assault is misplaced. Globalization is disruptive and will thus create both winners and losers. The wins will often be dispersed while loses will be focused. Hence, reaffirming the benefits of globalization requires constant reinforcement, yet also requires an appreciation that competitive trade may need localized support for those most disrupted 


Barriers to trade are being erected with tariff growing as a normal tool. Pandemic has restricted travel and the flow of labor. Regulations impeded the flow of capital. The global institutions of cooperation have failed at their mission. New and longer-term geopolitical tensions further erode the desire for cooperation and increased national competition. 

None of these trends toward deglobalization will be reversed without a conscience choice for global integration and cooperation. There needs to be champions for globalization that provide advocacy with candor; however, there first needs to be a recognition that deglobalization is a problem that needs to be solving. 

Geopolitical battle for oil - The other shock

The fall in crude oil prices is driven by more than a decline in demand. It is an intersection between private and state-controlled natural resource companies struggling for market dominance. Call this the battle of oil commodity mercantilism, state firms fighting for control, and privately funded firms suffering as active non-combatants. 

Private companies through US frackers are now the dominant producers of oil, and the state-run companies don't like it. Private firms are not innocent in this fight but as small firms they are driven by marginal cost considerations and the demands of their shareholders and lenders. State firms are bigger players, yet they cannot bend the will of global oil consumers when they lose market share. 

Saudi Arabia wants state firms through OPEC to control and stabilize prices. Russia would like to gain market share and further control of European markets. Standing in their way are the private frackers who have ramped up production through a combination of technology and old-fashioned leverage. 

While this is a Saudi-Russia quarrel on the surface, there is private firm fall-out. With a demand shock forcing prices lower, the state-run firms have an opportunity to grab market share and put the private producers out of business through using their lower marginal costs and higher financial pain thresholds. Although this may not have been conceived as a master plan earlier this year, the situation has evolved. Russian intransigence on production cuts has caused a Saudi production increase response to teach Russia a lesson on market power. The collateral damage but added benefit from the view of both Saudi Arabia and Russia is fracking shutdowns. A combination of higher marginal costs and high leverage make these firms vulnerable even if they have engaged in aggressive hedging programs. Forcing prices lower in the short run is possible through having deeper cash reserves and the ability to borrow. Those refinancing and funding in the high yield market will be casualties. 

This is all the result of state-controlled commodity mercantilism dominating the oil market. It is not a fair fight if you don't have the state backing you; however, the solution is not to play to the behavior of the mercantilist, but rather use innovation and technology to break the knot of state control. 

Use the BlackRock Geopolitical Risk Index as a substitute for year-end reviews

Investor mailboxes are being filled with year-end analysis and forecasts for 2020. These forecasts usually include some geopolitical analysis on potential risks for next year. Perhaps a simpler approach that may be more rigorous is to follow the BlackRock Geopolitical Risk Index which aggregates market attention across analyst reports, newsfeeds, and social media. The information is scored and aggregated to form an index on key risk topics. It is not the view of one analyst, but the aggregation of all opinions.

This is not a forecast of geopolitical risk, but a measure of attention. Attention can lead to market reactions; however, it can also represent the surprises that lead to large market reactions. As expected trade and US-China competition are the key current geopolitical issues. Overall geopolitical tensions are still high; however, the index has fallen from its peak, so any uncertainty risk premium may be falling. 

The index is worth watching for any investor that focuses on risk-on/risk-off  (RORO) factors. The index is especially helpful when in transition. Rising (falling) geopolitical suggest a time to move from risky to safe assets.

Geopolitical risks have fallen - Another good sign

There are many types of risks and uncertainties that investors face. Risk and uncertainty are not the same as market volatility. Risk reflects the dispersion in probabilities concerning future events and uncertainty reflects our inability to form probabilities on future events. These are not easy to measure, so investors may have to form proxies. 

There are now different indices for calculating different types of risk. There is the economic policy uncertainty index which focuses on news associated with government fiscal and monetary issues. See the economic policy uncertainty website for more details. There is also geopolitical risk index which focuses on news stories tied to key words like war and terrorism.

The description for the geopolitical risk (GPR) index can be found at the website of Dario Caldara and Matteo Iacoviello, geopolitical risk index. The index is based on text searches of 11 leading newspapers and counts key words and topics associated with geopolitical risk. The topics include: geopolitical risks, nuclear tensions, war threats, terrorists threats, and adverse global events. The text counts are normalized versus a base period and reported monthly. 

If this risk index increases, investors will likely reduce their holdings of risky assets and move to safe or risk-off assets. The authors show there are real and financial effects from shocks in the GPR index that are consistent with a flight to safety. By construction this index is not forward-looking and is reported with a lag, but there is still likely to be a lagged response by investors. A high GPR value increases the investment wall of worry. This alternative dataset provides some precision on any conversion concerning geopolitical risk.

A close look at 2019 suggests a link between the higher GPR index during the period of lower yields and lower equity values over the summer. The bond rally momentum has slowed with the decline in the GPR index. The country specific indices shows there has been a decrease in risk dispersion. 

Is the world safer or less risky? That question cannot be answered, but a normalized measure of geopolitical news narratives can tell us something about whether these risks are a focus for investors. 

AllianzGI Risk Monitor survey - Geopolitical risk on the rise, requires special thinking

If you tell me I have increased equity risk, I can adjust my asset allocation way from stocks and determine a good hedge strategy. If you tell me there is more interest rate risk, I can adjust my bond exposure and determine a hedge. But, if you tell me I have geopolitical risks, the choices or options become more complex. Geopolitical risks just don't happen often so we don't have a lot of countable events. Increased political risks will usually mean risk-off, but how this plays-out through a portfolio is less clear. It calls for more careful portfolio construction and diversification management.

The AllianzGI Risk Monitor survey is more important this year because it highlights a change in risk concerns. With over 750 respondents around the world, this year's survey, for the first time, places geopolitical risks at the top of the list with 40% viewing these as a concern.

The list of worries translates into equity market and event risks topping the polls. Both increased over last year. The geopolitical risks have made investors more wary of a tail risk event which can have a major impact on performance. Tail risk worries are up over 10% since last year's survey.

What are investors planning to do about these greater geopolitical risks? The survey suggests that there are two approaches for dealing with this market uncertainty. First, investors will continue to be active managers so options are open in order to nimbly react to change. Second, investors will continue to employ strategies to enhance diversification. When in doubt, hold a broad basket of asset classes and strategies that can be adjusted as needed.

What applies to the portfolio overall also applies to alternative investments. The survey emphasizes the important role of diversification from hedge funds. In an uncertain world, strategies that help maximize diversification should be in high demand. Global macro and managed futures fit this profile. These strategies have low overall diversification because they actively trade many asset classes. Additionally, managed futures has shown to generate crisis alpha or a crisis risk offset which will be extremely helpful if there is a geopolitical event that creates strong tail risks.  

Structural checklist for investment headwinds

Systematic models are very useful and important for disciplined investing, but the

percentage of the variation explained by most models in asset markets is relatively low especially over short horizons. The question for most managers, even quants, is determining how to deal with this percentage that is unexplained. There is no simple solution but applying a structural headwinds/tailwinds checklist may provide a good first pass for addressing the problem.

A structural headwinds or tailwinds checklist groups or categorizes issues that may provide a tilt to returns. These tilts on expected returns may lead investors to make a tilt or base adjustment to asset class allocations. Instead of starting with a base allocation of zero, there could be a negative or positive base allocation.

There could be more categories to this checklist, but these eight may get any discussion started. Some of these issues can be quantified, but we believe they often cannot explain short-term variation except if there is a shock. These factors can have an impact on returns through impacting the risk premiums in markets but only over long horizons.

Structural headwinds - A checklist

• Demographics - 
• The era of aging is upon us and it has an impact on capital flows and savings rates; just ask Japan or Europe. Demographics may include issues like the flow between rural and urban areas in China. It will drive return patterns even though it will not affect short-term volatility.
• Government -
• The type of government that is in place will affect investment options. Government impacts could include gridlock.  Venezuela is a perfect example for where government matters. The same can be said for Argentina or Russia.
• Regulation - 
• The Dodd-Frank regulation has an impact on returns but it is hard to model the impact directly. All of these rules on banks impact credit and the financial sectors. More regulation will have a greater impact on small cap stocks.
• Elections -
• BREXIT will impact all of the globe. The US presidential election may have a profound change on trade and global relations. The election dates are well known and may outweigh other model factors.
• Geopolitical risks (war - terrorism)-
• These risks usually lead to shock effects, but the changing probabilities of geopolitical risks will impact all returns; nevertheless, it is hard to include in any model. 
• Global trade -
• This factor refers to the overall integration of capital, labor, and good around the globe and not the trade balance of any one country.Globalization will impact capital market integration will effect the correlation across markets. 
• Climate - weather-
• While there has been much talk about climate change, the impact on investment returns is less clear-cut. Obviously, there are weather events that impact returns, but these can be diversified. 
• Technology - 
• Technology can provide a boost or a drag on specific industries. In the global macro arena, the impact of technology is less clear but the impact of technology on finance is real and does affect liquidity which is being priced in the markets.

Even if these factors are not explicitly modeled, they will affect allocation decisions and should at the least be catalogued and discussed.

BREXIT is the trade of the year

The BREXIT issue may be the trade of the year. What does that mean and why give it this view? 

1. This is a big event - Not only will this have huge impact on Great Britain and its place in the European and world economy, there will have a spill-over effect to the rest of the EU. This is the type of event that will shift rare event expectations and increase tail risks.

2. There is a specific date when uncertainty will be resolved. There is not an issue of when it will occur. We know the vote date.

3. The probability of the vote can be tracked and measured. Handicappers now say there is a 24% chance of an exit. The poll numbers look like it is very close. The risks of a bad outcome after June are still not clear, but the vote can be watched and given precision.

4. The market has already spoken that this is a big deal and talk is generating more interest. The IMF just stated that there will be severe global damage if the Brits leave. 

5. Financial institutions will have to square their risk books so there will be a liquidity effect and there will be a risk premium for those that hold these risky assets. This has started and will continue as we get closer to June. There will be a flight to quality effect regardless of the vote outcome. 

There may be better trades that develop through the year and ex post we find had a large pay-off, but this is the most measurable big event trade of the year.