Introduction to Geopolitics

Investors study geopolitics and geopolitical risk because they can have a material impact on investment outcomes. These relations affect key drivers of investment performance, including economic growth, business performance, market volatility, and transaction costs. On a portfolio level, geopolitical risk can affect the suitability of a security or strategy for an investor’s goals, risk tolerance, and time horizon. In this learning module, we will build a framework by which investors can measure, assess, track, and react to geopolitical risk, with a goal of improving investment outcomes.

• Geopolitics is the study of how geography affects politics and international relations. Within the field of geopolitics, analysts study actors—the individuals, organizations, companies, and national governments that carry out political, economic, and financial activities—and how they interact with one another.
• State actors can be cooperative or non-cooperative. A country may want to cooperate with its neighbors or with other state actors for many reasons. These reasons are typically defined by a country’s national interest—its goals and ambitions—whether they be military, economic, or cultural.
• The cooperation and engagement among countries is also affected by its resource endowment, standardization of the rules of engagement, and cultural factors and soft power.
• A country’s national interest can be viewed as a hierarchy of factors, with those essential for survival at the top of the hierarchy and nicebut-not-essential elements lower in the hierarchy. Governments use the hierarchy of interests to guide their behavior. 
• Political cooperation versus non-cooperation is only one lens through which geopolitical actors engage with the world, but it is an important one for understanding countries’ priorities.
• Globalization is marked by economic and financial cooperation, including the active trade of goods and services, capital flows, currency exchange, and cultural and information exchange. By contrast, antiglobalization or nationalism is the promotion of a country’s own economic interests to the exclusion or detriment of the interests of other nations. Nationalism is marked by limited economic and financial cooperation.
• Globalization provides potential gains, such as: 
  • increased profits—through increasing sales and/or reducing costs,
  • access to resources—market access and investment opportunities, and 
  • intrinsic gains—an improved quality of life.
• Globalization also has some potential drawbacks, such as: 
  • unequal economic and financial gains,
  • interdependence that can lead to supply chain disruption, and
  • possible exploitation of social and environmental resources.
• The International Monetary Fund’s (IMF’s) main mandate is to ensure the stability of the international monetary system, the system of exchange rates and international payments that enables countries to buy goods and services from each other.
• The World Bank’s main objective is to help developing countries fight poverty and enhance environmentally sound economic growth.
• The World Trade Organization (WTO) provides the legal and institutional foundation of the multinational trading system. It regulates cross-border trade relationships among nations on a global scale.
• A geopolitical framework for analysis includes four archetypes of country behavior: autarky, hegemony, multilateralism, and bilateralism. Each archetype has its own costs, benefits, and trade-offs with respect to geopolitical risk.
• Geopolitical risk is the risk associated with tensions or actions between actors (state and non-state) that affect the normal and peaceful course of international relations. Geopolitical risk tends to rise when the geographic and political factors underpinning country relations shift.
• The tools of geopolitics may be separated into the following three types:
• national security tools,
• economic tools, and
• financial tools.
• The most extreme example of a national security tool is that of armed conflict. Espionage is an indirect national security tool. Military alliances are often used either to aid in direct conflict or to deter conflict from arising in the first place.
• Economic tools are used to reinforce a cooperative or non-cooperative stance through economic means. Among state actors, economic tools can include multilateral trade agreements or the global harmonization of tariff rules. Economic tools also can be non-cooperative in nature. Nationalization is a non-cooperative approach to asserting economic control.
• Financial tools are the actions used to reinforce a cooperative or non-cooperative stance through financial mechanisms. Examples of cooperative financial tools include the free exchange of currencies across borders and allowing foreign investment. Examples of non-cooperative financial tools include limiting access to local currency markets and restricting foreign investment.
• There are three basic types of geopolitical risk:
  • event risk,
  • exogenous risk, and
  • thematic risk.
• Event risk evolves around set dates known in advance. Political events, for example, often result in changes to investor expectations related to a country’s cooperative stance. Brexit is an example of event risk.
• Exogenous risk is a sudden or unanticipated risk that can affect either a country’s cooperative stance, the ability of non-state actors to globalize, or both. Examples include sudden uprisings, invasions, or the aftermath of natural disasters.
• Thematic risks are known risks that evolve and expand over time. Climate change, cyber threats, and the ongoing threat of terrorism fall into this category.
• To make an assessment, an investor considers geopolitical risk in terms of the following three areas:
  • likelihood it will occur,
  • velocity (speed) of its impact, and
  • size and nature of that impact.
• Geopolitical risks seldom develop in linear fashion, making it difficult to monitor and forecast their likelihood, velocity, and size and nature of impact on a portfolio. As a result, many investors deploy an approach that includes scenario building and signposting rather than a single point forecast.
• Investors study geopolitical risk because it has a tangible impact on investment outcomes. On a macroeconomic level, these risks can affect capital markets conditions, such as economic growth, interest rates, and market volatility.
• Changes in capital markets conditions can have an important influence on asset allocation decisions, including an investor’s choice of geographic exposures.
• On a portfolio level, geopolitical risk can influence the appropriateness of an investment security or strategy for an investor’s goals, risk tolerance, and time horizon.