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