INVESTING

A positive twist on geopolitical risk?

Jeff Shen |Nov 18, 2019

Markets hate uncertainty, and the type deriving from geopolitical unrest has been heightened this year. Jeff Shen discusses why there may be a silver lining on the horizon for investors.

Geopolitical risks seem to be on a constant crescendo. Each day brings a new worry: Lebanon’s prime minister resigns, separatist groups raise their voices in Catalonia, street protests break out in prosperous cities such as Hong Kong and Santiago.

In the developed world, feelings of inequality arising from stagnant wages for the average worker have been feeding a sense of injustice. This, in turn, has driven populist politicians to power in many countries.

Taken together, these geopolitical risks have cast a pall of uncertainty. Markets notoriously hate uncertainty – and performance historically suffers as a result. But history has shown that the point at which very high uncertainty begins to trend down can be a particularly positive moment for asset prices. We are seeing such an inflection now in sentiment around countries’ economic policies and believe this could provide additional support to an already constructive environment for equity markets.

Quantifying geopolitical risk

Ranking and categorizing the significance of a discrete geopolitical risk is no easy task. Measuring its intensity and comparing it to past episodes are equally challenging. Most geopolitical events are their own unique unknowns without exact precedent.

What we can measure, thanks to modern computational techniques using natural language processing, is the intensity of public attention and sentiment around specific events. This type of analysis is reflected in the BlackRock Geopolitical Risk Indicator, which tracks 10 key geopolitical risk scenarios and their potential market impact.

We use these techniques in managing our equity portfolios, looking at the perceived level of economic policy uncertainty across individual countries. We use pre-trained “dictionaries” to screen analyst reports for key words to capture sentiment around a country’s economic policy backdrop. More than 5,000 analyst reports are reviewed daily to create an index of policy uncertainty for each country.

On balance, we have found that when policy uncertainty increases in a country, its equity market tends to under-perform—and vice versa. 

Time for a turn?

Our readings of perceptions around policy uncertainty are showing that the relatively high recent readings may have started to abate. The chart below illustrates the drop in many of the key countries we follow. To the extent this continues, it could provide a boost to risk assets.

Our confidence partly is backed up by the data trends: Sentiment metrics tend to be mean-reverting. In other words, they may spike, but they also historically have been shown to trend back to more “normal” levels. This could imply a more benign market environment ahead.

Geopolitical risk has been a wildcard for markets this year. In fact, it is geopolitics that have been an important headwind to an otherwise constructive environment for financial assets: Accommodative monetary policy is in play across multiple geographies, and many of the high-frequency economic indicators we track are pointing to a pick-up in growth. As China and the U.S. could be nearing a two-stage trade deal ahead of the 2020 U.S. electoral process, we see potential for the geopolitical headwind to shift to a tailwind.

Get Jeff’s take on the opportunity in China.

This is not to say some geopolitical events will not continue to escalate. U.S.-China tensions will almost certainly be subject to further ups and downs. But looking at and quantifying geopolitical risk in the aggregate, we find a drop from a very elevated uncertainty reading could be supportive of risk assets. This, we believe, argues for a continued focus on equities into year-end, but with a measure of resilience built in to cushion potential downturns.

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