Market AnalysisJan 24, 20264 Min

How Geopolitical Risk Is Being Priced Into Global Markets in Real Time

Outcomes in the stock market are always based on the current trends and events that are unfolding in the world. While you cannot anticipate these events beforehand, their impact on the global markets and market volatility varies significantly. The one trend that is currently looming all over the world is geopolitical risk.

There are wars, terrorism, and political tensions between different states. It necessitates pricing geopolitical risk in investments to protect your interests and investment. This further necessitates understanding the impact of geopolitical risk on stock markets.

What is Geopolitical Risk?

Geopolitical risk is the possibility of political occurrences that could destabilise the economy and international financial markets. These political occurrences include wars, conflicts, diplomatic tensions, sanctions, and terrorism.

These risks are systemic in nature because international trade, capital flows, and corporate activities are interconnected. They disrupt cross-border trade and investment, which can hurt stock prices and financial stability.

Impact of Geopolitical Tensions on Markets

Geopolitical tensions and stock market dynamics are closely interconnected. Increasing geopolitical instability tends to result in:

• Greater volatility in the market.
• Increased investor caution and decreased risk appetite.
• High demand for safe-haven commodities such as gold and government bonds.
• Changes in the asset prices in terms of changing geopolitical risk premiums.

Examples of the Impact of Geopolitical Risks on the Stock Markets

Here is how the global stock markets performed under different geopolitical risks:

Markets that were Most Affected by Each Geopolitical Event

• Pearl Harbor Attack (1941): The Pearl Harbor attack was a surprise military strike by the Imperial Japanese Navy against the US naval base at Pearl Harbor. The global markets were not as integrated at the time, and therefore, the effect was more focused in the US.
• JFK Assassination (1963): The sudden assassination of the US President John F. Kennedy led to a short-lived but sharp financial market shock. The spillover globally was not much since the shock was political rather than economic.
• Iraq’s Invasion of Kuwait (1990): The Iraqi military invasion of Kuwait caused an oil crisis in the world and a market crash. This invasion impacted the international equity markets, in particular the US markets, European markets, and Japan.
• Sept. 11 Attacks (2001): The terrorist attacks in the US impacted these markets the most: S&P 500, Dow, Nasdaq, FTSE, DAX, and CAC. It also impacted the travel and airline industries around the world.
• London Bombing (2005): A group of bombings in the transport system of London caused a temporary surge in market anxiety. The impact was significant on the UK market (FTSE 100). There was a weak spillover in European markets.
• Bombing of Boston Marathon (2013): The bombing of the Boston Marathon caused a short-term decline in the US markets due to increased security concerns. It impacted the US markets most, but the impact was short-lived.
• Russia-Ukraine War (2022): The full-scale invasion of Ukraine by Russia led to significant turmoil in the global market, particularly in Europe and the energy market. European markets faced the biggest blow, including DAX, CAC 40, and FTSE MIB.
• Israel-Hamas War (2023): The new war between Israel and Hamas caused stress and volatility in the regional market and economies, which are sensitive to energy. The Middle East Markets took the most hit, including the TA-35 index of Israel, Saudi Arabia, Qatar, UAE.

How Does It Affect the Market?

Here is how the geopolitical risk affects the stock market:

Elevated Geopolitical Risks and Financial Stability

The geopolitics in the world is still under tension. It is still a great threat to economic and financial stability. The economic activity is burdened by these disruptions, and they increase systemic risks. However, geopolitical risks are unpredictable and complicated, and when they happen, they are met with a sharp reaction in the market.

During large geopolitical events, the stock prices generally fall considerably, on average approximately 1% per month across the world, though up to 2.5% in emerging markets. The highest falls are seen in international military conflicts, particularly in the emerging markets, where the stock returns may decrease by up to 5%.

Sovereign Risk and Public Sector Impact

The high level of geopolitical tensions decelerates economic growth and raises government expenditure, which results in high sovereign risk premiums. Credit derivative spreads can increase by approximately 30 basis points in the advanced economies and even greater in the emerging markets by up to four times. This is an indication of increased fiscal susceptibility in the face of geopolitical uncertainties.

Cross-Border Spillovers and Contagion Risks

Geopolitical events not only impact the directly involved countries but also their trading partners due to financial and trade connections. The stock markets may fall by approximately 2.5% after a dispute with one of the key trading partners. The sovereign credit risks are also heightened, particularly in emerging economies with poor institutions, large public debt, or low reserves, and this increases the contagion risks across economies.

How Investors Act in Geopolitical Shocks

Here is how investors act in geopolitical risks:

• When investors are uncertain, they shift their capital out of risky assets such as stocks into safe havens such as gold and bonds.
• An increase in geopolitical uncertainty causes investors to seek higher returns on risky assets to reflect the perceived increase in risk.
• Investors will de-expose themselves to sectors and areas that are directly affected by geopolitical tensions and move to more resilient or defensive sectors.
• Geopolitical shocks lead to abrupt and sharp changes in prices in world financial markets, where large sell-offs are usually followed by rapid recoveries as soon as the situation becomes clearer.
• Investors diversify portfolios across countries, sectors, and asset classes to reduce geopolitical risks.
• Investors intensify due diligence of political events and reposition accordingly depending on the direction of geopolitical tensions and the possible effects of policies.

Mitigation Strategies to Maintain Financial Stability

The following is a detailed bullet-point list of mitigation measures for financial stability in the framework of geopolitical risks:

• Maintain Sufficient Capital and Liquidity Buffers: Financial institutions must have sufficient capital and liquid assets to absorb losses and carry on lending in case of a geopolitical shock to ensure continuity of operations.
• Conduct Stress Tests with Geopolitical Scenarios: Stress tests that include realistic geopolitical risk scenarios should be conducted regularly by regulators and institutions to identify their vulnerabilities and create contingency plans.
• Incorporate Geopolitical Risks into Risk Management: Incorporate geopolitical risk factors into credit, market and operational risk models to enhance anticipation of effects on portfolios and loan quality.
• Encourage International Cooperation and Coordination: Enhance cooperation between central banks, regulators, and international organisations to coordinate standards, exchange information in a timely manner, and reduce cross-border financial contagion.
• Support Emerging and Vulnerable Markets: Strengthen local capital markets, preserve fiscal policy space, and accumulate adequate international reserves to enhance resilience to shocks.
• Invest in Innovative Technology and Cybersecurity: Use AI, data analytics, and strong cyber defences to identify, track, and act efficiently on the fast-changing geopolitical threats, such as cyberattacks on financial infrastructure.
• Increase Crisis Preparedness and Governance: Maintain well-defined governance structures and hold frequent crisis simulation exercises to be prepared and respond to the crisis.
• Balance Regulatory Oversight and Market Efficiency: Have clear, coordinated policies, including sanctions and trade controls, which reduce unintentional disruptions without disrupting market functioning and transparency.
• Foster Diversification and Risk Hedging: Encourage business operations, investments, and supply chains diversification across jurisdictions to mitigate the impact of local geopolitical instability.

To Conclude

Geopolitical risk takes its place as a core cause of market volatility and investor behaviour in the modern globalised economy. Recent geopolitical crises show the physical effect of these risks on market volatility, investor sentiment, and asset price changes in equities. Ultimately, successful investing amid geopolitical uncertainty requires balancing caution with opportunism and aligning investment strategies with long-term economic fundamentals.

Disclaimer: The information provided in this article is for educational and informational purposes only and should not be considered financial, investment, or trading advice.