Refresher Reading
Introduction to Geopolitics
2024 Curriculum CFA Program Level I Economics
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The international environment is constantly evolving. Such trends as the growth of emerging market economies, globalization, and the rise of populism impact the range of opportunities and threats that companies, industries, nations, and regional groups face. They can be impacted by changes in regulation, disrupted trade flows, or even conflict.
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. These relations matter for investments because they contribute to important drivers of investment performance, including economic growth, business performance, market volatility, and transaction costs.
Geopolitical risk is the risk associated with tensions or actions between actors 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. A shift could arise from a change in policy, a natural disaster, a terrorist act, a theft, or war.
Investors study geopolitical risk because it has a tangible impact on investment outcomes. On a macroeconomic level, these risks impact capital markets conditions, including economic growth, interest rates, and market volatility. Changes in capital markets conditions can, in turn, have an important influence on asset allocation decisions, including an investor’s choice of geographic exposure. 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. A higher likelihood of geopolitical risk can raise or lower an asset class’s expected return or impact a sector or company’s operating environment, affecting its attractiveness for an investment strategy.
There is no shortage of ways in which geopolitical risk can impact a portfolio, so identifying, assessing, and tracking geopolitical risk can be difficult and time consuming. It is thus important for investors to map those potential risks to tangible investment outcomes. In this reading, we will build a framework by which investors can measure, assess, track, and react to geopolitical risk, with a goal of improving investment outcomes.
Learning Outcomes
The member should be able to:
- describe geopolitics from a cooperation versus competition perspective
- describe geopolitics and its relationship with globalization
- describe tools of geopolitics and their impact on regions and economies
- describe geopolitical risk and its impact on investments
Summary
- 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. There are many reasons why a country may want to cooperate with its neighbors or with other state actors. These reasons are typically defined by a country’s national interest.
- National security or national defense involves protecting a country, its citizens, economy, and institutions, from external threats. These threats may be broad in nature—from military attack, to terrorism, crime, cyber-security, and even natural disasters.
- Geographic factors play an important role in shaping a country’s approach to national security and the extent to which it will choose a cooperative approach. Landlocked countries rely extensively on their neighbors for access to vital resources. Countries highly connected to trade routes or countries acting as a conduit for trade may use their geographic location as a lever of power.
- Generally, strong institutions contribute to more stable internal and external political forces. Countries with strong institutions, including organizations and structures promoting government accountability, rule of law, and property rights, allow them to act with more authority.
- 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, anti-globalization 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. - In general terms, regions, countries, and industries that are more dependent on cross-border goods and capital flows will have higher levels of cooperation.
- The interdependent nature of globalization may reduce the likelihood that collaborative countries levy economic, financial, or political attacks on one another. However, interdependence can make cooperative actors more vulnerable to geopolitical risk than those less dependent on cooperation and trade.
- A geopolitical framework for analysis includes four archetypes of country behavior: autarky, hegemony, multilateralism, and bilateralism. Each archetype has its own costs, benefits, and tradeoffs with respect to geopolitical risk.
- The tools of geopolitics may be separated into 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 via economic means. Among state actors, economic tools can include multilateral trade agreements or the global harmonization of tariff rules. Economic tools can also 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 via 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.
- 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.
- 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 impact 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 a period of 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.
Scenario analysis is the process of evaluating portfolio outcomes across potential circumstances or states of the world. Scenarios can take the form of qualitative analysis, quantitative measurement, or both. - Investors study geopolitical risk because it has a tangible impact on investment outcomes. On a macroeconomic level, these risks can impact 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.