How and Why Geopolitics and Headline Risk Are Different

Published earlier this week on LinkedIn's The Pulse (see the original post HERE), this essay explains why it is crucial to distinguish between headline risk (which is transitory) and geopolitics (which is pervasive).

An important discussion is underway within the economics profession regarding the relationship between geopolitics, headline risk and market volatility. These are serious issues that merit more discussion.

Today's post provides a visual synopsis of the main arguments in the LinkedIn post. You can find individual shareable versions of each image on the BCMstrategy, Inc. Twitterfeed.

The full text of the article appears below for your convenience.

The Wall Street Journal today twice proclaimed the all-clear regarding geopolitical risks HERE and HERE. Building on research from a Nobel Prize winner (NYU’s Dr. Robert Engle), investors are advised to ignore geopolitical risks. The perspective aligns well with a classic value investor focus on fundamentals in the belief that a solid investment makes sense regardless of the policy environment in which a company operates.

But with all due respect, a blanket strategy to ignore geopolitical risks results in mis-estimating and under-pricing exposure to shifts in public policy trajectories. An ostrich approach may be an appropriate reaction function for headline risk, but it should not be confused for strategic risk management, particularly regarding positions in regulated industries. In fact, an ostrich approach increases exposure to headline risk when policy volatility spikes, resulting in missed alpha generation opportunities and sub-optimal hedging/increased exposure to losses. 

Geopolitical risk is not disappearing.  Nor is it random. Geopolitical risk is not the conceptual equivalent of a dart board or a lightning bolt from the sky. Closely monitoring the policy process makes it easier to spot inflection points as they build, thus decreasing the risk of a surprise shift. In the technology world, the term for this process is “superforecasting.” It can be automated. We do it every day at BCMstrategy, Inc. using our patented process, and then we measure it.

To be fair, until recently it has been impossible to price geopolitical risks because sufficient and appropriate data did not exist to support robust risk measurement. Automated analysis of vast data sets combines today with access to alternative structured data extracted from the language of the public policy process to facilitate for the first time concrete measurements of geopolitical risks…..and the exposure of every company to those risks. 

In the language of market risk measurement, geopolitical risks have been viewed as “general” market risks which permeate the investment horizon and impact all positions. Understanding the existence of general market risk drove development of diversification strategies and financial engineering solutions to measure and manage correlations within and across asset classes. I had the privilege of working with many financial engineers that pioneered this work at global banks in the early 1990s. The new generation of alternative data makes it possible to transform geopolitical risk from general market risk into specific risk, which in turn increases the precision and array of potential risk management (and alpha generation) mechanisms to address real and tangible spikes in risk for individual asset classes and investments triggered by geopolitical risk.

But first, it is crucial to distinguish between headline risk and geopolitical risk. Too many otherwise informed observers conflate the two concepts. 

Geopolitical Risk is Different From Market Liquidity Risk and Systemic Risk

Geopolitical risks exist always and everywhere since sovereigns seek to advance objectives through a range of means. In the post-war era, a plethora of international organizations were created to place structure around this process. These structures are now under stress in the rapidly accelerating Distributed Age, as discussed in this blogpost for the Bretton Woods Committee last year. For present purposes, the point is that cross-border inflection points and stress events have always existed and will always exist since sovereign interests rarely experience a 1:1 correlation. 

The most recent financial crisis ten years ago fed a misperception that geopolitical risk is the same as headline risk. For example, Bloomberg reported last year that Dr. Engle’s most recent research[1] shows a low impact of geopolitical risks on asset market volatility. But the definition of geopolitical risk in Dr. Engle’s study seems to have been: international events that impacted all asset classes across countries. This is the wrong definition of geopolitical risk. It is too broad.

Financial policymakers have a term for events that impact all asset classes across countries…..but that term is NOT geopolitical risk. Nor is it even headline risk. The term is: systemic risk or market liquidity risk. More colorful terms include: market crash, contagion risk, financial meltdown.

Equating geopolitical risks with a global financial market collapse is profoundly problematic. 

It confuses risks emanating from cross-border sovereign competition and inflection points (geopolitics) with chain reaction events in the capital and banking markets (systemic risk). Geopolitical risks are not the sole trigger for contagion or spillover risks that impede market execution by driving prices down, intensifying losses, and/or making execution impossible. 

Using headline-driven situations as a proxy for geopolitical risks can create problematic outcomes by confusing correlation with causation

Between 2008-2015, geopolitical, headline and systemic risks were all indeed correlated, compliments of the considerable challenge of unwinding a broad range of long-dated financial market and economic exposures that had under-priced a range of risks including, but not limited to, geopolitical risk. Consequently, it is understandable that many would conflate geopolitical risk with systemic risk. 

However, post-crisis regulatory reforms created more distributed, insulated international economic and financial market interdependencies, making the system less vulnerable to systemic risk from any trigger (including, but not limited to, geopolitical risks). In particular, ring-fencing regulatory capital and subsidiarization requirements have so far successfully impeded transmission of cross-border systemic risks. It would have been shocking if Dr. Engle’s research had identified any systemic risk events. 

However, curbing systemic risk transmission is very different from eliminating the market reaction function regarding geopolitical risks

Silence (lack of market volatility correlated to headline risk) does not indicate safety (insulation from geopolitical risk) just as transitory bot-driven market volatility does not indicate a shift in fundamentals. 

Exposure to shifts in policy triggered by international relations still exist and must still be managed even in the absence of correlated systemic or market liquidity risk. In fact, more dynamic and explicit efforts to manage exposure to geopolitical risks can help minimize vulnerability to market volatility associated with geopolitical risk.

Equating geopolitical risk with headline risk is similarly problematic. 

Ever since the 1987 “program trading” market crash in the United States, policymakers and market participants have struggled to manage the reaction function between headlines and market volatility. From the advent of the ticker tape to today’s automated algorithmic execution engines, the velocity of information flows has rewarded fast, event-driven execution even as it has apparently accelerated the intensity of market volatility. 

However, headlines usually are the last place where geopolitical risks appear….not the first. 

As a former policymaker myself, I know from experience that most strategically significant policy decisions occur when things are quiet. When headlines are focused on other issues, policymakers have the political space to strike strategic deals. The decisions are often previewed publicly before they are made. Headlines are a lagging….not leading….indicator of policy risk. Economists and technologists miss this basic point because most of them have never had the honor of being a public servant. 

Handling headline risk requires managing exposure to incremental signals of policy shifts during the quiet periods so that fewer headlines deliver a surprise that adversely impacts investor interests.

Consider the Group of Twenty process depicted in the infographic above. An impressive array of policymaking occurs throughout the year on many technical issues in the typical G20 policy cycle….far away from summit-related media spotlights. Activity levels understate the risk of a shift in policy trajectory for any given issue because for each international meeting at least 2-3 separate meetings occur at the national level. 

Most G20-related shifts in policy trajectory never trigger a headline. Some are executed without controversy; others are too technical to attract attention. Sometimes a policy shift in one makes international policymaking unnecessary. Sometimes national action dictates the summit outcome months later. In most cases, the time horizon for executing on policy decisions does not correlate neatly with options expiration dates or quarterly reporting deadlines. These decisions can materially impact baseline assumptions supporting investment decisions and strategic corporate investment decisions, resulting in mis-priced or under-appreciated risks.

Equating geopolitical risk with headline risks misleads investors and strategists into thinking that geopolitical risk is a completely random variable that cannot be measured, managed, or priced. Consequently, latent exposures to geopolitical risk increase as headline risk decreases. Just because geopolitical risk does not trigger systemic risk does not mean it has lost the ability to generate adverse impacts. Consider:

·      Multi-year interest rate or FX swaps with periodic re-set dates create latent (unmeasured, unpriced), dynamic exposures to monetary policy decisions when those decisions are impacted by geopolitical/geoeconomic situations. Relegating geopolitical risk to the stochastic, “impossible-to-manage” random variable means implicit exposure to significant shifts that can materialize only when they are too late to address/hedge – when volatility and headline risk materialize.

·      Corporate sales and investment decisions generate multi-year exposure to policy risks at home and abroad. They are uniquely exposed to geopolitical reaction functions over a long time horizon. Determining that these risks are not manageable thus ironically increases exposure to risk (i.e., unanticipated outcomes).

·      Individual investors with a buy-and-hold strategy – and their life cycle mutual funds or ETFs – can hope to ride out periodic headline risk storms. But their individual investments generate significant latent exposure to structural shifts in every regulated industry from energy and financial services to pharmaceuticals and technology. 

Monitoring it, measuring it, and managing it requires a level of discipline, resources, and expertise that are in short supply in capital markets. The answer is not to act like an ostrich and hope that geopolitical risk will not impact the economics of an investment decision. The answer is to approach this risk class with respect, armed with the full scope of next-gen technology. We can help with that. To find out more about how BCMstrategy, Inc. can help your company monitor, measure, and manage geopolitical and regulatory policy risks, CONTACT US today.

[1] Note: I searched unsuccessfully for a published version of this Dr. Engle's research. It seems presentations regarding the findings have been made to select audiences, particularly at the ECB and Bloomberg. But the papers and details were not available to the average internet researcher. Consequently, my description is based on how that research was reported; some nuances may have been omitted by the editorial process. If I should be fortunate enough to read the research, I may update this essay accordingly.