Geopolitical Risk – The Fear And Reality For Financial Markets by Colin Moore, ColumbiaManagement

  • Most geopolitical events do not lead to significant or persistent global market reactions.
  • Conflicts confined to areas remote from significant world economic activity and which do not threaten oil supplies tend not to impact markets.
  • While the emergence of new geopolitical risk may cause markets to fall, this is often short lived as investors assess the impact of the risk on their assumptions of earnings and cash flows.

Given the threat of geopolitical risk, it is reasonable to question why global financial markets remain so buoyant. The answer may partly be the constant nature of geopolitical risk. Consider the French proverb “plus ça change, plus c’est la même chose” (the more things change, the more they stay the same). It only takes a cursory search to find quotes from ancient philosophers dealing with the certainty of uncertainty. For example, Pliny the Elder is credited with the phrase “In these matters the only certainty is that there is nothing certain.” It has always been difficult for investors to construct a portfolio which allows for the small probability of one of these geopolitical threats escalating into a crisis that significantly affects market returns. Therefore, the more important question may be, “Has the nature of geopolitical risk changed thereby increasing the probability of disruption to markets?”

To analyze an issue, one must first define it. A common definition of geopolitical risk is the risk of one country’s foreign policy influencing or upsetting domestic political and social policy in another country or region. Unfortunately, this definition does not fully encompass the scope of today’s geopolitical risk. Some risks fit this definition (e.g., Russia’s annexation of Crimea and support for separatists in the Ukraine, China and Japan’s dispute over various islands, Iran’s support of Hezbollah), while others do not. A growing number of groups are aligned with an ideology rather than a traditional country, e.g., Boko Haram in Nigeria, Islamic State in the Levant (ISIL). These groups represent significant geopolitical risk. Furthermore, as a collector of old maps, I see constant reminders of how unstable countries and their spheres of influence can be. The creation and subsequent collapse of the world’s great empires involved changing political structures and, more often than not, armed conflict. Wars may but do not necessarily impact markets. Pronounced and prolonged market reaction appears to depend on where the war occurs, whether it spreads, and/or how much it impacts globally significant commodities such as oil.

Our analysis suggests that regardless of the level of bloodshed, armed conflicts confined to areas remote from significant world economic activity and which do not threaten oil supplies tend not to impact markets. It should be noted that there may be a brief nervous reaction from investors while these criteria are assessed. The ability of conflict to spread to areas of greater economic activity or rather the fear of spread appears to be affected by the involvement of a “superpower” or “superpowers.” The definition of a superpower and the type of superpower involvement are pertinent to answering the question, “Has the nature of geopolitical risk changed?” To be a superpower, it appears that a country/region/group needs to meet three criteria:

  1. Control or influence approximately 20% of global GDP
  2. Have a significant military capability
  3. Have the ability to project that military power globally

The U.S. is the only country that controls 20% of global gross domestic product (GDP) but the European Union as a whole controls/influences more and China is getting close. Russia does not have sufficient control or influence, but their attempts to reassert the level of influence the Soviet Union enjoyed is clearly a source of geopolitical risk. All have significant military strength, but European Union (EU) coordination of the use of their member state military is limited and China lacks the ability to project power due to their relatively small naval presence. It is difficult to act as a global superpower without naval and air power that can be projected globally. Consequently, the U.S. is the only current major power meeting all three superpower criteria. It is evident in their actions that Russia and China are unwilling to accept the status quo. Both countries are clearly seeking to assert more influence in the territories adjacent to their homelands but also on the broader global arena. We must expect China to significantly expand its naval presence, which in turn will create the potential for greater tension with the U.S. In the interim, China is confined to but increasingly assertive in its territorial claims in the South China Sea, etc. Although regional in scope, these actions create potential global geopolitical risk by increasing tension with several neighbors including Japan, Vietnam and the Philippines. Both Japan and the Philippines are likely to call on U.S. naval support if the tension with China escalates to armed conflict.

While Russia has significant naval and air resources, it is not clear to what extent they need to be modernized/upgraded. Russia has embarked on a campaign of reasserting economic and political influence over the former Soviet Republics. Until recently, the principal tool used to unlock resistance was energy. The virtual regional monopoly Russia enjoys in the marginal supply to gas to Europe via Gazprom allowed it to surreptitiously reassert influence. However, the escalation of events in eastern Ukraine has raised the visibility of Russian intentions and raised the risk of the spread of conflict. Russia is clearly testing NATO and EU responses but we do not believe they intend to engage in a war. More likely, we will see increased “Cold War” activity which has global consequences for the levels of defense spending. The risk to financial markets may not be through an escalation of armed conflict in Ukraine, but rather through a diversion of economic resources toward defense which may not have the same multiplier effect on global economic growth as other forms of investment. A significant fear for investors is the lack of momentum in global economic growth, and anything that undermines confidence in increasing expansion may impact valuations.

Recent geopolitical events have illustrated how the nature of geopolitical risk is changing. The nature of U.S. military involvement in various crises is a key change. The U.S. continues to demonstrate its willingness to commit naval and air resources. However, as first seen during the civil war in Libya, again in Syria and in combating ISIL, the U.S. has become less willing to commit troops to resolve global conflicts, which is forcing others such as Japan and the EU to reconsider their role in resolving conflicts. In a similar vein, Saudi Arabia has become less willing to be the swing producer to resolve oil supply gluts, which may force Russia and Iran to reconsider how they cooperate to resolve the issue. In a recent study from the Brookings Institute (The Sultans of Swing? The Geopolitics of Falling Oil Prices, by F Gregory Gause, III), the author points to the following possibility after an analysis of previous severe oil price declines:

“In all of these cases, despite serious geopolitical tensions between Saudi Arabia and Iran, lower oil prices led the two countries to cooperate in the oil arena to try to put a floor under falling prices and

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