Geopolitics Drives Uncertainty and Downside Risk

  • Consider currency hedges since negative geopolitical events primarily transmit via currency.
  • Consider buying stocks on the dips to profit from mean reversion.
  • Don’t necessarily rely on bonds as proxies, as investors treat bonds differently from currencies or stocks when a geopolitical  event happens.

After years of indifference, in 2018, markets responded strongly to geopolitical events. Two simultaneous developments drove the change. First, global central banks (led by the Federal Reserve) reversed years of monetary easing after peak liquidity in 2016–2017. While the pace remains unclear, the trend toward further tightening should characterize 2019 and may make markets more sensitive as liquidity declines further. Second, geopolitical risk has increased as the world order continues to undergo a transformation. International organizations, treaties and laws have gradually begun to cede influence to the unilateral actions of major countries, based on raw political power. The lack of transparency around these unilateral decisions by executive administrations is likely to lead to regular market surprises. Volatile price moves are the natural consequence but may present opportunities, as well as risks, for investors.

US Policy Impact

In both instances, these developments are led by the United States. While the US has been the main source of monetary and geopolitical volatility, US markets have been the beneficiary relative to the rest of the world. We believe this pattern will continue throughout most of 2019.

Trump’s “America First” has upset the status quo on issues where a strong domestic constituency is lacking.  As a result, there have been a number of geopolitical triggers in 2018 that could have further implications for investors in 2019. In Figure 1, we highlight several examples of geopolitical price action based on US policy moves.


Market Impact of US Policy


These moves are likely to have secondary and tertiary effects, for example, on companies within complex supply chains or those with specific regional exposures that may have to alter their business models or absorb additional costs.

Hotspots for 2019

Other areas of the world are also likely to be affected by geopolitics in 2019. In the map below, we pinpoint the hotspots for geopolitical activity that could have an impact on markets in 2019.


Hotspots for 2019


These moves are likely to have secondary and tertiary effects, for example, on companies within complex supply chains or those with specific regional exposures that may have to alter their business models or absorb additional costs.

At the global level, we expect the US–China dispute to continue as there is presently no obvious exit strategy for either country. Equally, Russian interventions in conflicts and external elections continue, and reciprocal sanctions are unlikely to ease.

In the Middle East, the confrontation with Iran is likely to loom large, with proxy theaters in Yemen and Syria. In a worst-case scenario, we could see provocations in international waters or inside Gulf countries — all of which could have an impact on oil prices.

Venezuela, too, is likely to continue to be a factor in commodity markets. It appears to have passed a point of no return from an economic perspective, triggering the largest refugee crisis in Latin America, and having spillover effects on Colombia. Further escalation of this situation could invite intervention from external actors, such as the US.

With regard to Korea, we expect the détente to last until 2020, assuming that there are no inflammatory moves by either side.

Finally, the European Union is strained on three levels:

  1. Brexit: the need for the EU to maintain unity and strength as a trade/regulatory bloc while ensuring the UK meets its outstanding liabilities.
  2. Italy: ensuring the credibility of monetary union (the trajectory is either repeated bouts of economic crises or erosion of monetary orthodoxy).
  3. Poland/Hungary/Romania: facing down challenges to the legal and political order, with a sharp reversal of country fortunes possible with the renegotiation of the EU budget cycle.

Any resolution of these geopolitical themes could trigger re-ratings in the markets they affect and should be monitored over the coming months.


Key Milestones in 2019

What to do as an Investor

To understand how investors might factor geopolitics into their investment decisions, we studied how emerging markets have reacted to geopolitical events over the past 30 years.1 We found clear patterns in currency and equity markets but no consistent outcomes in bond markets.

For currency markets, negative events led to an instant depreciation, on average of -0.64% within two trading days, whereas positive events barely registered a market reaction. To add context, we note that the long-term average monthly performance of the currencies in the study was -0.66%. So in the wake of a negative event, currencies undergo the majority of their expected monthly fall in just two days. After this initial shock, currency trading reverts to normal patterns, but does not necessarily reclaim the original loss over the subsequent 12 months. As Figure 2 shows, currency performance normalizes, but even one year later, positive events have led to a 2% outperformance relative to the historical average.


Annualized Currency Performance


For equity markets, Figure 3 shows the effect of geopolitical events on returns for stocks within local MSCI indices. This chart illustrates the rolling monthly equity performance relative to historical averages. Instant reactions reflect the positive or negative nature of any event and are far more symmetrical than those in currency markets. Higher frequency data suggest that equity markets display a somewhat higher degree of anticipation for those events than currency markets. Weekly and monthly results are pronounced, both in absolute terms and in relation to historical returns. In other words, positive events lead to a consistent outperformance. For instance, one month after a negative event, equity indices tended to be, on average, 2.02% below their pre-event level.


MSCI Local-Currency Monthly Rolling Returns, Basis Points Above/Below Historical Average


The three-month point after events is critical to understanding the length of the event impact. At this point, on average, indices return in nominal terms to pre-event levels. The gap between performance after negative and positive events collapses, and performance begins to mean-revert for both types of event. Therefore, the effects of geopolitical events typically seem to last somewhere between one and three months, but the differential performance during those initial weeks is not erased.

This historical performance suggests several investment actions during periods of heightened geopolitical risk:

  1. Consider currency hedges. Since negative geopolitical events primarily transmit via currency, periods of higher risk could justify currency hedging, depending on the base currency. This can be abandoned once geopolitical tensions dissipate.
  2. Consider buying stocks on the dips. Eventually, geopolitical crises settle into a new equilibrium and equity markets then tend to mean-revert to historical performance, albeit from a lower base. Similarly, although positive events are usually telegraphed in advance, investors can capture the tailwinds from the de-escalation of conflicts.
  3. Don’t necessarily rely on bonds as proxies. US Treasuries aside, resident and non-resident investors treat bonds differently when an event happens, due to different base currencies as well as differing perceptions about what constitutes a safe haven during periods of stress.

Petrov, Alexander; Hentov, Elliot; and Zumbo, Fabrizio. "How Does Geopolitics Affect Financial Markets?" September 2018.
Note: Averages across all positive and negative events where data is available, weighted equally across four markets; results annualized. Source: Bloomberg, State Street Global Advisors Research, 2018.
One basis point (bp) is equivalent to 0.01%
Note: Averages across all positive and negative events where data is available, weighted equally across four markets; results annualized. Source: Bloomberg, State Street Global Advisors Research, 2018.

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