Geopolitical Uncertainty and How It Affects Investment Behavior
Let’s turn the pages of history and go back to September 1, 2011, when the WTC bombing took away precious lives and deeply affected the economic system of the US.
The attack that was carried out at the heart of the US financial system took a toll on the GDP as well as the performance of financial markets. This also had ripple effects on the value of the USD as well as major institutions of the country.
In short, the 9/11 incident posed what we call a great geopolitical risk to the markets at that time. This risk emerges from a threat to the political stability of a geographical region and affects investor behavior as much as it affects other macroeconomic indicators.
Let’s study the subject matter deeper:
How is the geopolitical risk quantified?
One of the most widely used metrics to quantify geopolitical uncertainty is the Geopolitical Risk Index (GPR). This index takes into account reports published by eleven national and international newspapers and screens out specific keywords such as ‘terrorism’, ‘extremism’, ‘threats, and ‘wars’.
As cited by the Federal Reserve’s of America, the GPS is developed by considering the number of occurrences of such events. The index was first constructed in 1985 and is calculated on a monthly basis. Once the text searches are run, an audit is carried out to make sure the findings are accurate and bias-free.
Every time, this index goes beyond 100 points, the period is known to carry geopolitical risk.
How does geopolitical risk affect investor behavior?
In times of geopolitical uncertainty, investors are said to drift away from securities that carry heavy risk. In times like these, they move toward safer assets.
By ‘safer’, we mean any investment vehicle with short-term maturities. Government bonds, for instance, are said to benefit in times like these whereas the stock market usually suffers.
The first component of the investment infrastructure that gets affected is the trade channels. Geopolitical uncertainty makes trading costly and reduces the demand for domestic currency among exporters.
This affects capital inflow and promotes capital outflow from US citizens. On a macro level, the government‘s fiscal policy is also affected.
To keep up with the inflationary pressures, the government levies heavier taxes on consumers. This reduces and average citizen’s purchasing power and makes it harder for them to invest.
As a result of these developments, investor sentiment and confidence is also deeply affected. Investors are unsure of the direction they’re heading to. Investments become more volatile and losses become easily obvious.
As cited by Investopedia, this risk can occur as a result of a change in government, legislation, foreign policy, or military involvement.
Is gold a safer option?
During the Iraq War of 2003, the MSCI Index yielded -9% whereas gold returns stayed fixed at 5.6%. Going a bit further in the pages of history, let’s consider the unfortunate 9/11 incident. During this time, the same MSCI index yielded -14% whereas gold retained its value at 8.9%.
As cited in another study, currency spot markets are quicker to react to such uncertainties compared to equity and gold markets. A currency spot market can even lose much value in as little as two days compared to equity and gold market that may take as long as two months.