Do Financial Market Investors Truly Understand the Nuances of Geopolitical Risks?
Tags: Politics, Economics, Entrepreneurship, Finance, Business

Introduction

Geopolitical risks have been on the rise as of late. In fact, it can be suggested that it was involved in building the 20th century and will do so in this century. President Donald Trump’s presidency brought it to the forefront of politics but its presence has been felt long before his arrival as US president. But do financial market investors understand its nuances?

What exactly is Geopolitical Risk?

Geopolitics has long been cushioned in the understanding of statehood and its broader relations with its neighbours and the international community. One can go as far back as the Roman empire to discover its importance to statehood. But its scholarly roots can be traced back to the 19th century.

Three key writers act as the foundation of the field. Joseph MacKinder, Friedrich Ratzel, and Nicholas J. Spykman. The summation of their work highlights the importance of territory to statehood derived from their individual security. The field however has broadened beyond territory to the seas, airspace, and the internal characteristics of countries. Cyberspace is also an interesting arena of geopolitics. In this way, they can be categorized as traditional geopolitics and critical geopolitics.

The summation however is that geography is important to statehood and affects its behaviour internally and externally. Geography encompassing land, people, culture, politics, and more. Geopolitical risk is when these actions become a risk. When it poses danger to its safety, to that of its region, and to the broader international community. A few examples come to mind like the US-China Trade war, UK’s referendum to leave the EU, Scottish Independence, Russia-Syria relations, and more.

Perceptions of the Financial Markets to Geopolitical Risks

Financial markets have had a lukewarm relationship with geopolitical risks. Despite the prominence of geopolitical risks during Trump’s presidency. Even prior, a plurality of events demonstrated the omnipresence of geopolitical risks. Events such as:

failing states in the Middle East, ongoing conflict in Iraq, Syria, Libya and Israel, war tensions between Russia and Ukraine and the Ebola epidemic in Africa.

Despite these phenomena, financial markets did not adjust long term asset pricing accordingly. Perhaps this is understandable. An example is the killing of the Iranian General, Qasem Soleimani.

US-Iranian relations date back to the 20th century during the embers of the Cold War. America then was preoccupied with holding back Soviet influence in the Middle East region or movements for Communist support in the region. Europe was oil dependent on the region and America wanted to strengthen Europe economically so as to hold back the Soviet Union. Should Soviet influence grow in the region, there was concern in the US that the USSR would deprive Europe of oil supply and therefore, quash their European economic agenda.

Richard Nixon and subsequent presidents sought to alleviate America's pressure of defending the world and leasing its military globally. Perhaps the real reason Nixon wanted to pullback was to focus on Vietnam. But this was America’s policy position. America would work through allies it helped build up. Iran and Saudi Arabia were members of this group in the Middle East.

Though during President Jimmy Carter's tenure, US-Iranian relations were unstable. This was due to the close relations of the US with the Shah, King Mohammad Reza Pahlavi who abused his people. Carter’s government-backed him because his government believed he brought stability to the region. But US-Iranian relations were already sour thanks to the 1953 coup of the democratically elected Prime Minister Mohammad Mosaddegh by the US and the UK. Saudi Arabia was also in turmoil at the time.

However, Carter still reiterated the distancing of US policy in the region. It was unwise to suggest the US as the ‘dominant power’ of the region during this tumultuous period. Of course, Bush’s tenure reversed this but Obama brought it forward. Obama’s policy mirrored Carter’s. He worked through multilateral institutions, quick missions and would prevent long US campaigns in the region. The Obama government did not see the need for the US’ extensive involvement in the region unless it posed a direct threat to US security interests. Regarding oil, the US is also largely self-sufficient.

Whether or not Russia poses a threat to the US is also questionable. After the official breakdown of the USSR, Russia is no longer a serious threat to Europe which is economically prosperous. Though this can be questioned. Following the failure of Russian democracy with the presidency of the father of Russian democracy Boris Yeltsin and the installment of Vladimir Putin as Russian president, USSR geopolitics has taken sway in Russia. Evidence of this is demonstrated through current Russian actions such as the annexation of Crimea.

Moreover, following the US’ deflated response to the Iranian retaliation of the killing of their beloved General, markets carried on as normal with the understanding that war would not be a reality. The Geopolitical risk was not inherent and the potential for conflict eroded meant markets probably understood these circumstances. But can this really be the case?

Perhaps. The Efficient Market Hypothesis suggests so.

Geopolitics in the E.M.H. Theory

The Efficient Market Hypothesis is a theory on asset pricing. Financial investment is the act of purchasing assets in exchange for a future return. The magnitude of this return is based on the price you pay for the asset. Investors will pay more for investments that have a significantly high payout in the future and less for the antithesis. So then how do you know what price to purchase an asset? This is the central question of asset pricing theory.

Eugene Fama: The father of the EMH theory. Source: Wikipedia

The foundation of the theory is that all that there is to know is a reflection of current market prices. In other words, it suggests that market prices are a reflection of all available information. In the context of a market-driven by competition for profits, low transaction costs, and easily available information, markets are ‘efficient’. It would be unwise to suggest that investment professionals could beat the summation of the entire market because the conditions do not allow for this.

To do so would mean to be smarter than the entirety of the market. Coupled with this, one must also be faster. If markets are competitive and employ information for profit, then prices change rapidly. The only way to outcompete in the market would be to acquire new information and be faster at deriving the value of this information. The issue is, per EMH, new information is random.

It is not possible to predict what new information is coming out. It is not possible therefore to know more than the overall market and therefore, it is impossible to outcompete the overall market. This means price movements are random in nature. If new information drives asset prices and new information is random, then asset prices change randomly.

Thus, to outcompete in the market, one would essentially have to be able to ‘time travel’ into the future. This is the only way to outcompete in the market per the EMH. This is impossible. The underlying theory suggests informational advantage and speed is the key to outperforming the profits of the entirety of the market. EMH market contextual environment, suggests this to be a difficult task.

If this is how the market works according to the EMH, then markets should also understand the rationale behind the Iranian killing as explained previously. Markets' competitiveness through knowledge acquisition is core to their success. Therefore, it can be assumed that financial markets, per the EMH, do have an innate understanding of geopolitical risks.

According to EMH, it would be impossible to know what Trump was going to do before it happened, his intentions for it until it happened. But once it did, the market would be quick to price this into asset values. This occurred. Prices of equities dropped in anticipation of war only to rebound when this was quashed. It is also possible to assume that the reasons and background given above were also priced into the asset values.

But how confident can we be about this? Can we truly say that prices were driven by the understanding of the geopolitical implications of the act, or just a random response to a random event?

If EMH is followed upon, then it suggests that even attempting to understand the geopolitical risk implications of the event is not worthwhile. The only reason one would engage in seeking informational advantage, if this is possible, would be to earn more profits. But if this is impossible, then why learn anything? Or better yet, why even try to compete for profits?

If prices are a true reflection of asset values, just buy a collective portfolio of assets and do nothing. It's not worth it doing anything if your efforts are going to be for naught.

Moreover, if we assume to operate in a highly competitive market, then market participants will be driven by their neighbour, not by discipline expertise. Competition indicates one wants to be better than their neighbour. Therefore, they will seek to know more than what their neighbour knows. This could mean starting with what they know and build on it. It suggests investors will not go beyond the purview of the disciplines the collective market uses to make investment decisions. If markets are driven by economic news and models of how the world works, then a market participant need only learn more than their neighbour in this regard. Can we truly be sure then that market participants are aware of geopolitical risks? Prices, therefore, are a reflection of what the collective market knows, not what is known in the entirety of the world.

One could argue that being more competitive means going beyond the bounds of market participants' knowledge. Stepping out of the financial world and into politics, economics, psychology, and more. This certainly is a phenomenon. Markets are broadly well versed, pricing in a range of disciplines. But then this would defeat the premise of EMH. It would suggest that new knowledge is not unpredictable, just distant from market participants’ purview. For asset prices to change, one would not need to rely on only new random information but rather new information that was beyond their attention.

In this way, they create new knowledge. But much of innovation is an iteration of what is already known either reconceptualized in a different context or re-arranged in a different order. This still would defeat the omniscience of the market and thus that of geopolitical risks. It's not sufficient therefore to assume markets just know geopolitical risks but rather are incentivized to seek them out.

Though the competitive nature of the financial markets per the EMH suggests this could be half-baked. Competition encourages comparisons. Market participants would therefore only seek out innovations their neighbours lack. It is an iteration of what their neigbours have to possess what they do not. Employees who are specialized in particular disciplines, from different parts of the world, demographics, and technology their competitors lack.

Certainly, this suggests financial market investors, institutional and retail, would seek out broad knowledge expertise and geopolitical risks could be one of them. But the game would not be to seek education but knowing enough to be profitable. If it's not profitable, it's not worth knowing. So an in-depth understanding of the discipline could be assumed to be lackluster.

Market participants, at least institutional, are driven by business needs. So often, investment decision making is based on investing for financial targets rather than discipline expertise. Though this may be relied upon, it is only possible to the extent of the potential to make profits.

For example, most international institutions, state and non-state, tend to house successful professionals in their fields. Davos for instance a non-profit organization that acts as a medium for world leaders from various disciplines to culminate ideas and understandings of their respective fields. For financial professionals, it's how markets work. However, a geopolitical understanding of the world seems to be lacking.

For instance, the World Economic Forum accounted for a range of factors such as the need for

fiscal stability in the developed world (US and UK) in 2010, but not Greece; it failed to account for the Arab Spring in 2011; since 2009 crisis, the WEF have failed to understand or factor more deeply the economic capabilities of the US and the overcapacity of global governance.

But U.S. hegemony is still resilient and multilateral institutions are still functional as evinced during the 08' financial crisis and activities conducted through the G-20.

Innovation takes time before profits are realized. For institutional investors in the financial markets, their priority is to keep their jobs. To do so, they rely on already established precedents that are money makers. If innovation is engaged, it is only an iteration of this. ESG products are a good example of this. This does not do enough to tackle Climate Change, it's half-baked.

Focus on Traditional financial metrics

It is widely believed that Central Bank’s liquidity has been driving financial market returns over the past decade. This has been on the rise since the 2008 financial crisis. The market’s pain tolerance towards geopolitical risks has thus been strengthened. In this manner, they could be considered as a trusted partner for financial market investors as their decisions allow investors to remain within what Warren Buffet describes as their circle of competence. They pay closer attention to traditional economics, valuation, and investment risk management allowing them to have a degree of control over the proceeding developments. Why go beyond what is working even if you seek to outcompete?

US-China trade tensions is an interesting case. Markets have certainly been paying attention. A BlackRock index, based on sentiment from financial industry news outlets like Bloomberg and Refinitiv, demonstrates markets have been extremely attuned to the events surrounding these two superpowers over the past 15 years. This is understandable. Both countries are the world’s two largest economies and thus any friction between them will have dire economic consequences.

Concerns spiked to an all-time high in 2011 until Obama decided to pivot to Asia. Hillary Clinton explains why here. In essence, the 21st-century superpowers gained their status not through military might as was the case in the 20th century but through economic prominence. This is characteristic of China’s and the remainder of Asia’s prominence.

The US not giving the region attention was it defaulting its position as a superpower. What did the financial markets think? Apparently not much. The below Blackrock index demonstrates a comparison between the likelihood of the event and the impact on the equities market.

The data shows a cluster of geopolitical risk factors’ likelihood being high but equities impact being fairly flat. Only two seem important to equities and these have economic underlying consequences. Perhaps if geopolitical risks are understood within the context of what financial markets deem canon, then it's possible to suggest they are aware of it.

Perhaps the type of financial asset is also important. Equities are driven by so many variables. Geopolitical risks are just a slither of the variables markets pay close attention to. Financial markets’ attention span is therefore short and follows the money.

Commodities and currencies are more driven by geopolitical risks because of the internationalism attached to them. Research by State Street Global Advisors demonstrated currencies to be quick in responding to negative global events. The same was also the case for commodities due to the global supply chain. For equities, they found that geopolitics only mattered if it affected the earnings of the underlying companies. It is also widely understood that developed market equities are less affected by geopolitics compared to emerging-market assets. The latter are less established politically and economically and less predictable so are perceived as more risky investments.

Geopolitics As A Source Of The Market’s Sanguine Nature Towards Its Risks

We have been told Central Banks, in this case, the Federal Reserve, are usually solely responsible for controlling inflation but this is not solely the case. In fact, geopolitics has a central role to play in this. Post world war two, we have been living in a multi-polar world which has been argued to stem from US hegemony; the Pax Americana where one powerful nation coordinates global affairs to restore order. Analogies are usually made with the 19th century Pax Britannica:

The Cold war challenged this but the downfall of the Communist regime in Russia in the late 1980s, free market capitalism became the global norm. With this in place the US was able to rid itself of the Cost of Living Adjustment (COLA) which wages was indexed against. With free market capitalism becoming ubiquitous, the restraints of globalisation loosened and thus enabled the reduction of labour costs and reduced wage cost inflation.

If globalization is disturbed, it would reduce the ability of the FED to have primary control of inflation. Politics enables them to perform their functions efficiently.

Perhaps the markets have not had to consider geopolitical risks due to US hegemony. This has essentially harmonized the global governance rules due to its collective representation of interests. Thus, the financial markets have been able to simplify and focus on financial issues; valuations, and financial-economic risks. This could be suggested through the RaboResearch which is based on Caldara and Iancoviello (C&I),

a geopolitical risk index using words related to geopolitical risk in the US, Canadian and British newspapers, using a range of terms aimed at capturing risk and incidence of conflicts of global importance and its relevance to the economy.

In this study, it was found that though geopolitical risks posed significance to the financial markets, its significance was minor. Also, there were limited fluctuations in the US Treasury Bills within the context of geopolitical risks. This is a result of US hegemony.

However, this stability is being disrupted and American power is being challenged by the likes of China, Russia, and other states who are now fully developed and can pursue their own interests. This instability disturbs these global rules but the ‘framework’ of global governance persists.

This hegemonic stability may explain why geopolitical risks are priced into emerging-market assets and why developed markets are considered safe havens, despite rising tensions as of late. We can see this in the below as the US has the largest market capitalisation in comparison to other countries.

Markets perhaps have been so comfortable in this environment that they don’t necessarily see this as an issue to consider and are overly optimistic on its future outlook. Perhaps the markets perceive these as fat tail risks that can be managed using the traditional tools of risk management; VaR and other financial-economic metrics. Possibly, this limited understanding of geopolitical risks has caused them to focus their conception as events with durations rather than seeking the theories that underlie these events. Perhaps the markets are more literate than expected and they treat it as a minor risk metric, taking a back seat to more traditional investment and financial metrics.

Geopolitical Risks Baked Into Traditional Financial Market Metrics

There seems to be high demand for sector-specific funds which may have geopolitical risks baked into their investment methodologies. Healthcare in the US tends to be a politically dense sector. Sector-specific funds have experts who understand these complexities and mold them into the investment criteria. Technology also and the increasing geopolitical risks of cybersecurity are probably baked in the various funds in existence.

Perhaps the financialization of markets is a symptom, although studies on the financial crisis seem to somewhat undermine this. Perhaps investors have lost confidence in geopolitics and global investible themes demonstrated by the reducing net Asset Under Management of global macro funds. Although this could be attributed to their being hedge funds which have come under pressure for high fees and lackluster performance, not necessarily the investment strategy. Moreover, Global Macro is a broad discipline looking at various global macro themes; not quite like its sub-sect niche geopolitical risks.

In Conclusion

Geopolitical risks provide new ways of thinking about markets, an interdisciplinary manner for studying phenomena, themes, and new market relations. This could be an immature frontier considering trends such as Financial services not necessarily having the tools needed to derive and prepare for them. Thus, we need more than just Bloomberg news terminal data, we need specialists to delve deeper into the understandings of geopolitics to derive meaningful geopolitical risks that are relevant for the financial markets.

Investors are easily elated by change and disruption when contextualized in their traditional pockets of knowledge and this certainly seems to have given relevance to geopolitical risks in US-Chinese rations and the market’s awareness of a potential cyberwar. But it is still not habitual. Global Politics and the subsequent geopolitical risks will be important in this evolving world, driving competition, supply chain locations, regulations, sector concentration, and more.

As Jeff Bezos always says, “It’s always day one”.