Is Mr. Market Apolitical? Not quite

Geopolitical risks and uncertainties posed by elections, polarization, and conflicts within and between countries will continue to play on investors’ minds this year and likely beyond.
In this paper, we look on impact of geopolitical events on markets through a lens of “known unknowns” and “unknown unknowns” ─ a risk framework devised in a famous speech by a former United States Secretary of Defense Donald Rumsfeld in 2002.
We find that elections in the U.S.—a typical example of “known unknowns”—do not appear to have had a significant impact on the U.S. large caps in the time period considered. Market volatility appears to spike in autumn for most years, whether there are presidential elections or not.
In the case of “unknown unknowns”, such as wars or terrorist attacks, sharp market selloffs and increased risk premium have been observed, but they typically have dissipated within weeks. Investors can either ignore this temporary turmoil and remain invested in the portfolios optimal for their investment objectives or take a more active approach and act on the greater risk premium in order to capture potential higher returns (which unsurprisingly come at higher risk).
We believe that focusing on the longer-term, structural changes following certain geopolitical events might help investors to better position their portfolios for future uncertainties without introducing downside in calmer times. We suggest the use of the Geostrategic Risk Rating (GRR) as one practical tool for factoring geopolitical uncertainties into a portfolio.

1 / Introduction

Geopolitical risk encompasses a broad range of different phenomena, including political instability, tensions and military conflicts between countries, terrorist threats or other events that can have regional or global impacts. It can also be used in the context of internal political affairs, which can influence domestic and global financial markets.^[1]

The war in Ukraine and the Israel-Hamas conflict continue to worry governments, central banks and investors because of their knock-on effects on the economy, both globally and for individual countries. Elections have also been a key political theme this year, as over half of the world’s population has voted or will vote in general or local elections in 2024. Some elections may have limited local or regional effects, others – have not or will not produce surprising outcomes. A number of elections could have significant foreign policy implications. For example, the recent Taiwanese elections could reshape China-U.S. relations, while Iran’s political landscape may influence the Israel-Hamas conflict and commodity prices. In the European elections, while the center right held ground, the strong showing for far right parties across the continent now have the potential to impact policymaking in Brussels. However, the most significant attention this year has been focused on the U.S. elections and a potential return of former President Donald Trump.

“There are known knowns; these are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns – the ones we don't know we don't know”

Donald Rumsfeld, Former United States Secretary of Defense, 2002

The global economy can be affected by geopolitical events both directly and indirectly through financial, trade and commodity price channels due to changes in tax policy, regulatory environments, industrial policy and other legislative actions of governments. In terms of financial markets, this happens both through direct capital controls or financial sanctions, and indirectly through increased uncertainty, higher risk premia or asset price surges. Prolonged policy uncertainty, as during the long years of negations after the 2016 Brexit referendum, constitute another important transmission channel, changing both fundamentals and risk perceptions.

In this paper, we look at geopolitical risk and its impact on capital markets through the lens of “known unknowns” and “unknown unknows”. This framework of risk originates from a speech by a former United States Secretary of Defense Donald Rumsfeld (see the quote above).