Quantifying Geopolitical Risk

Throughout 2019, geopolitics and trade conflicts were a fixture in the news. Now, as we near the end of the first month of 2020, there remain a number of geopolitical storylines that have yet to play out. These include the contentious Trump impeachment trial and November elections, ongoing turmoil in the Middle East (punctuated by the skirmish with Iran in early January), and continued friction between the US and China.

With all of the geopolitical variables that remain in play, investment managers need to stay on top of the potential impact geopolitical risks may have on their portfolio, but the signal to noise ratio here is notoriously hard to navigate.

The question we’ve sought to answer is, can we isolate the impact of geopolitical events using a risk factor, similar to other factors that we’ve presented in the past (e.g. Exchange Rate Sensitivity)? In answer, we’d like to introduce the Geopolitical Risk Factor, courtesy of our partners at Wolfe Research, as we kick off a multi-part series on the Geopolitical risk.

Today, we’ll first attempt to define the factor and show its performance, as well as provide our weekly market and factor update.

What is Geopolitical Risk?

‍The methodology that Wolfe leverages to define geopolitical risk and their subsequent measurement of it is derived from an academic paper called Measuring Geopolitical Risk(Caldara and Iacoviello, 2018), the latest version of which can be found here.

In that paper, geopolitical risk is defined as “the risk associated with wars, terrorist acts, and tensions between states that affect the normal and peaceful course of international relations. Geopolitical risk captures both the risk that these events materialize, and the new risks associated with an escalation of existing events.”
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How is the Geopolitical Risk Factor constructed?
In the Caldara and Iacoviello paper, they built an index that counts the frequency of articles related to geopolitical risk from leading international newspapers published in the US, UK, and Canada, and then measure it against impact to the US and global economy, and the US and global markets.

The Geopolitical Risk Factor (GRF) is then, simply, a measurement across a model universe of stocks with high and low return sensitivity to the geopolitical risk index constructed in the paper.

‍How has the Geopolitical Risk Factor performed?

‍Here’s how the Geopolitical Risk Factor (GRF) has performed on a cumulative basis over the past 3 years:

Cumulative Returns: Geopolitical Risk Factor (1/1/17 - 1/23/20)
Here, we can see that the factor experienced a steep decline throughout most of 2017, bottoming out at -1.44% on 8/7/17. From that point on, it’s seen mostly positive movement, save for a few drawdowns in Jan 2018 (US Government shutdown), Dec 2018 (trade tensions and US market pullback), and April 2019. The factor crossed over into positive returns in mid-2019, and has mostly rallied in Jan 2020.

Here’s a magnified view of the last six months:

‍Cumulative Returns: Geopolitical Risk Factor (6/23/19 - 1/23/20)

We can see that the risk index took off during this period with the exception of a strong downward move in September (impeachment initiated and attack on Saudi oil facilities). This included a strong positive move at the beginning of 2020, despite the Soleimani assassination and subsequent murmurs of an imminent world war.

It’s important to note that while this is a secondary factor that doesn’t move as much as other factors like Volatility, it does tend to move more and has a larger impact during times of heavier geopolitical headlines.

Furthermore, in this factor model, the GRF’s returns are completely independent of all other factors. In other words, this return represents a pure alpha move in excess to the other factors in the model. So when we see that the GRF was up 0.71% in the past six months, it means that there was +0.71% of alpha explained by this factor. This indicates to us that there is value in tracking this factor relative to one’s portfolio.

It’s surprising to us that stocks with high GRF exposure have rallied during the recent news cycle, and warrants further investigation. Next week, we’ll perform a deeper dive into this phenomenon by examining the GRF at the sector level.

US & Global Market Summary

US Market: 1/17/20 - 1/23/20

• The major indices closed slightly lower on Friday (not captured in above chart), with investors digesting earnings and cautiously monitoring the spread of coronavirus in China and abroad.
• The IHS Markit flash PMI for manufacturing dropped to a 3-month low in January, while the services PMI strengthened to its highest level since March 2019.
• Next week will bring several key tech earnings reports from the likes of AAPL, MSFT, FB, AMZN, as well as CAT, XOM, and UPS.
• The Fed will also meet for the first time in 2020 next week, and is expected to hold rates steady after Fed officials indicated that they plan on keeping interest rates static for a while.

‍Factor Update: US Model

• Profitability continued its climb back towards neutral, up 0.15 standard deviations over the past week.
• Growth saw slight positive gains, as it creeped up further into Overbought territory.
• Volatility fell out of Overbought space after dropping 0.31 standard deviations, now sitting at 0.68.
• Earnings Yield descended beyond -2 standard deviations, earning an Extremely Oversold designation
• The abrupt rotation out of Value continued, as it fell away from exactly neutral to -0.75 standard deviations from the mean.
• US Total Risk (using the Russell 3000 as proxy) fell by 0.11%

‍Factor Update: Worldwide Model

• Growth continued its ascent, up 0.34 standard deviations in the past week and closing in on Extremely Overbought territory
• The bleeding in Earnings Yield slowed down, as it sits on the cusp of an Extremely Oversold designation.
• Volatility and Market Sensitivity both saw negative normalized returns, with Market Sensitivity falling towards Oversold territory.
• Similar to the US, Value saw a massive downtick in normalized returns, falling more than 1 full standard deviation in the past week and edging towards Oversold space.
• Global Risk (using the ACWI as proxy) decreased by 11bps

Regards,
Omer