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In fact, geopolitics has been around since ancient Greece, when Aristotle criticized Plato’s concept of a republic because it didn’t account for the impact of the actions of neighbouring states on a society’s welfare. It has waxed and waned as an investment risk ever since.
The Treaty of Westphalia that ended Europe’s Thirty Years’ War in 1648 gave us the modern nation-state. (Previously, European politics had been driven by religion and royal families.) These new states were discrete entities that experienced geopolitical conflicts over access to resources.
After the terrible world wars of the first half of the twentieth century, economic integration was seen as a way to tilt individual countries’ war/peace cost-benefit analysis toward peace. Europe stands out in this effort, but global efforts began with the General Agreement on Tariffs and Trade in 1947 (the predecessor of the World Trade Organization) and the creation of the International Monetary Fund (IMF) and the World Bank.
Global integration accelerated after the collapse of the Soviet Union in 1989–90 on the assumption that improved global flows of goods, services, and capital best served the well-being of individual countries. Geopolitics was a slow-moving overarching theme that investors needed to be aware of but not spend much time on.
So globalized had the world become that, by 2015, then brand-new Prime Minister Justin Trudeau described Canada as the world’s first “post-national state.” 1
The tide was already turning, as highlighted by the first election the very next year of Donald Trump as President of the United States. Today, the early actions of Trump’s second administration challenge comforting assumptions about a quiescent geopolitical landscape.
Geopolitical risk—like any risk—measures the probability that outcomes will differ from expectations. One of the most widely used benchmarks is the Geopolitical Risk Index (GPR) devised by Dario Caldara and Matteo Iacoviello.2 It’s a simple measure of the frequency of news media coverage on geopolitical tension.
Geopolitical risk does look set to remain elevated.
Figure 1 shows the correlation between the GPR and returns on the S&P 500 Index since 1990. It shows extreme negative correlations (a high GPR accompanied by sharp drops in the S&P 500) during events like the 9/11 terrorist attack, Brexit, and Russia’s invasion of Ukraine. It also shows that negative correlation continuing, with President Trump’s trade war and ongoing great power competition, according to Matt Gertken, Chief Geopolitical Strategist at BCA Research.
Figure 2 reinforces that the correlation isn’t spurious: although equity market volatility as measured by the Chicago Board Options Exchange (CBOE) Volatility Index (VIX) isn’t always accompanied by a rise in the GPR, since 1990, a spike in the GPR has consistently been accompanied by higher market volatility.
Geopolitical investment risk transmits most directly via currency markets and, relatedly, interest rates. In equities, the key variable is simply the perceived overall risk level, says the former Chief Investment Officer at Alberta Investment Management Corporation (AIMCo), Marlene Puffer, CFA, PhD.
Foundational to equity valuation is the equity risk premium and the risk-free rate, historically based on the US 10-year Treasury. Leaving aside speculation about the long-term reliability of US institutions, questions about the near-term impact of US government policies on inflation and monetary policy are putting upward pressure on US Treasuries and the risk-free rate, Puffer notes.
Practitioner Strategies for Managing Geopolitical Risk
To succeed in managing geopolitical risk, investors need both quantitative and qualitative approaches, says Matt Gertken.
Markets face geopolitical risk when nonmarket actors (e.g., governments, protest movements, insurgencies) act in ways that influence markets. Gertken advises investors to identify the key non-market actor and that actor’s specific policy priority that affects the investment decision.
To assess the risk, estimate the likelihood that the policy will be implemented, as well as the actor’s own evaluation of the benefits of success and costs of failure.
“It’s important to tie a geopolitical risk assessment to an actionable investment conclusion so that you can ask afterwards: ‘Did that assessment improve performance?’” Gertken says.
➜ Do your homework
Marlene Puffer emphasizes that thorough research, scenario planning, and robust debate are irreplaceable.
geopolitical considerations.
“You need the right internal structure and challenge mechanism so that the macro view and the voice of the risk team are taken into account,” she says.
➜ Unique private wealth considerations
For high-net-worth individuals or family offices, geopolitical risk management presents unique challenges, says Brian Madden, CFA, CFP, Chief Investment Officer at First Avenue Investment Counsel Inc. and Board Chair of CFA Society Toronto.
“Every client thinks about risk in their own unique way,” says Madden. “Before we invest a single dollar, it’s crucial that we understand both their risk appetite and risk tolerance— and those aren’t always the same thing.”
Unlike institutional investors, private clients may lack a formal geopolitical view, placing more responsibility on wealth managers to account for such risks.
“We have to assess their total risk budget and be really clear about the nature of all risk—including geopolitical—that our approach may encounter.”
Behavioural nuances also loom larger in wealth management. Some geopolitical risks may provoke a particular emotional, patriotic, or cultural response for clients. Madden says that managing those reactions is all part of the client relationship, but there’s a duty not to let them override the cold calculus of investment decision-making.
“We’ve misjudged something about their risk preferences, tolerance, or appetite.”
“Sometimes, it’s easier to just avoid the really hot potatoes,” Madden concludes.
It’s not so much the level of risk as the uncertainty about the direction that is kryptonite for markets, though. To illustrate, a rise in global tariffs affects the profitability of different industries and investee companies. But if tariffs are just used to extract concessions and then rolled back, those profitability effects may be undone.
“So much of the investment outlook currently is policy-driven; investment decisions are difficult,” says Puffer. “Because the drivers and range of possible outcomes have become broader, we may have entered a thematic zone characterized by under-investment and muted global returns.”
Geopolitical risk does look set to remain elevated. The GPR has never revisited the multi-decade low it hit at the turn of the millennium with the collapse of the Soviet bloc. A changing landscape Despite widespread commentary that current White House trade policies are misguided and aimed mainly at financing both new and renewed domestic tax cuts, deeper trends more broadly underlie both the tariffs and heightened geopolitical risk.
First, rapid globalization has prompted populist movements in many countries, fueled by economic, social. and political inequalities, notes BCA Research’s Gertken. “Now that states have started to enforce borders and impose trade taxes, there’s an entire class of media and society that had a distorted sense of the importance of commerce and finance and that’s now frustrated and bewildered because it didn’t understand that states and borders still matter,” he says.
Second, economic relations have become intertwined with broader national security interests. After the COVID-19 pandemic exposed the risks of globalization by interrupting supply chains, government policy swung back toward securing domestic supplies. At the same time, dominance in key industries and control of strategic materials is seen as offering leverage in increasingly adversarial geopolitical relationships, notably between the US and China.
“Economics is no longer purely about the financially beneficial flows of goods, services, and capital,” says Jonathan Fried, a retired Canadian diplomat and fellow at the Canadian Global Affairs Institute. “Today, economic security and national security are increasingly intertwined in government policy and business planning alike.”
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