Commentary Type

Historically, Geopolitical Risk Has Had Little Market Impact

Adam S. Posen (PIIE)

Excerpt from the article "Why Is the VIX 'Fear Gauge' So Low?" by Jim O'Neill, Scott Bessent, Adam Posen, and Mohamed El-Erian, in the International Economy, Spring 2017.

The world today is a cauldron of global political uncertainty. Yet the VIX, the popular measure of the implied volatility of S&P 500 index options, is at its lowest level in years. Four noted analysts tackle the question in the International Economy. This excerpt is from PIIE President Adam S. Posen.


It may not make much sense that geopolitical risk has little equity market impact, but it should not surprise us. Historically, even actual outbreaks of war or recurrent terrorism have caused little in the way of deviations of market outcomes from their usual patterns—and when they have had an impact, those impacts have tended to be transient. This is an empirical regularity of outcomes in the wealthy West, definitely since nuclear deterrence and avoidance of direct great power wars have come into play.

But going back further into the nineteenth century, and wider into economies more exposed to credible if not existential threats, the impact of geopolitics on market outcomes has been limited as well. There have been some negative effects of national security uncertainty on long-term economic performance—as well as more importantly and far more awfully on human lives directly—even if not on stock prices or volatility. That says something about how stock prices and profits are determined by the lasting insulation of incumbent businesses and by political redistribution towards capital and particular sectors, more than it says anything about geopolitical risk being unimportant.

Even large-scale conflict and the tides of history rarely change who is rich.

To put it much too bloodlessly, we have run a bunch of natural experiments on market reaction to changes in perceived security risk.

  • The risk of nuclear war arguably went down a lot in the immediate aftermath of the Cold War ending in 1989, and then rose significantly as nuclear weapons technology proliferated to unstable or inimical regimes more recently. Average national savings rates moved little in response to these stark changes in threat, as opposed to the large changes that business cycles and the financial crisis had.
  • Large withdrawals of US and Soviet troops from locations around the world, notably Germany, Eastern Europe, and the Philippines, seemed to matter little for economic outcomes on their own in terms of geopolitical risk (though of course their withdrawal allowed the marketization of Eastern Europe).
  • The 9/11 attacks on the United States led to costly and widespread imposition of new standards of homeland security, including at the borders with Canada and Mexico, and imposing transactions costs and time burdens on travelers and shippers. According to most polls, Americans felt less rather than more safe, and if anything overestimated the risk of terrorism. Neither of these facts led to any deterrence of the great market bubbles of the early and mid 2000s.
  • Countries truly beset by ongoing terrorist threats, ranging from Colombia to India to Israel to Thailand to Turkey, saw increases in inwards direct investment and sustained stock market appreciation. Of course, some of this was due to the success of various anti-terrorism and security measures undertaken by their governments—and when there was outright civil war in Colombia, there was an economic cost to go with the horrible human toll. But geopolitical risk being higher on an ongoing basis for these economies did not make their stock indices underperform over time.

Even large-scale conflict and the tides of history rarely change who is rich, and that is probably a large reason why stock markets do not respond to geopolitical risk very much. As leading trade economists Donald Davis and David Weinstein pointed out with creative research in 2002, the bombings that flattened Japan in World War II did not prevent the same commercial centers from being dominant there after the war as before (other scholars following their example found similar evidence for other post-calamity recoveries). A recent paper by Guglielmo Barone and Sauro Mocetti, released by the Bank of Italy, documents that largely the same families are rich and poor in Florence in 2011 as were in 1427. If your relative wealth as a stockholder or investor can be unchanged by seven hundred years of history including invasions and civil warfare, it's hard to see why an equity holder in today's United States or European Union should worry much on the geopolitical front.

It is horrible, and may well be evil, that rich Western governments can inflict social destruction on other countries by military means (see Iraq, Afghanistan, Libya, and so on), and send off their own poorer young citizens to risk death inflicting that destruction. But for all the talk of blowback, doing so hardly puts their investments at risk, except perhaps in consumer brands. Even that consumer threat is exaggerated when thought of in narrow financial terms, since the countries that are failed states or home to terrorists are usually much the same as the countries that are not integrated with the global economy.

It is the internal political stability of the rich economies, and the possibility of redistribution or strong regulation (neither necessarily bad), that presents any real uncertainty for equity investors. Responding to perceived geopolitical threats with economic nationalism will probably harm national economic growth and certainly harm productivity, but may actually be good for incumbent businesses and their owners' profits.

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