Geopolitical volatility returns to the financial markets

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Rarely since the 1970s has the global economy seemed so turbulent. The march of globalisation has slowed. The dual shocks of the Covid-19 pandemic and Russia’s invasion of Ukraine have muddied monetary policy and upset energy markets and supply chains. Economic nationalism, US-China tensions, and fragmentation have taken root. Governments are taking a bigger role in economic management, particularly faced with the urgency of the climate transition. The tragic return of conflict to the Middle East only underscores the pattern of rising geopolitical risk.

Market indicators reflect this. The Vix index — a measure of expected volatility — has averaged notably higher since 2020 than in the decade before. The World Uncertainty Index, which measures the prevalence of the word “uncertain” in analysts’ reports, has been trending upwards for years and has jumped significantly since 2021. The more uncertain future is altering the playbook of market participants, from investors to central bankers.

First, quantitative models used to price assets and assess trends are less meaningful. A couple of decades of relative stability, underpinned by growing global trade and few political shocks, made it easier to forecast macroeconomic variables, such as growth, interest rates and inflation. It was simpler to assess how these would evolve when underlying assumptions about the world were fewer and simpler. Today, economics is increasingly influenced by politics and foreign policy.

Looking beyond charts, balance sheets and ratios has its own implications. Markets do not have a great record of pricing geopolitical risk and assessing low-probability, high-impact events, or “tail risks”. Studies show that economic activity and financial markets are often more affected by geopolitical threats than actual events. But equally, when there are several threats that are complex and hard to define, markets can be stumped into inertia. Indeed, oil prices rose but not as much as expected in response to Hamas’ attacks in Israel. There may be adjustments ahead.

The difficulty of measuring geopolitical premia also raises the reward for those that can get it right. There is a growing demand for professionals who can combine political and macro knowledge with financial fundamentals. Returns at macro hedge funds — actively managed traders that attempt to profit from swings caused by events — surged between 2019 and 2022, following a decade of dull returns. Last September, hedge funds that took bearish bets on sterling, as the then British Prime Minister Liz Truss’ spendthrift agenda ruptured markets, made handsome profits.

Volatility may also induce traders to seek returns by adopting more active short-term strategies. Zero-day options, which allow investors to take targeted positions in stock markets around events, have surged in popularity since the start of the pandemic. Institutions with passive long-term strategies, such as pension funds, are also affected. There is now less conviction in even decade-long economic and political trends, meaning diversification, including into alternative assets, becomes attractive. The problem is that the cost of misjudging events is also high: research shows market volatility widens the range of returns for active funds.

Policymaking in this environment has already proven challenging. Central bankers’ interventions are based on historical data. But with the world ahead in flux, the chance of errors is higher and the effectiveness of monetary policy, which operates with a lag, is dimmed. Rigid financial institutions, including market regulators, will struggle.

Attempts to parse geopolitical events only introduce more human error into markets. Active strategies, shorter time horizons, less focus on models, and policy errors all risk creating a vicious cycle of instability. The world of higher-for-longer volatility may be hard to shake off.