Power play

Read this article to understand:

• Why geopolitical risk has risen in recent years
• How using geopolitical risk assessments can help build resilient EM debt portfolios
• Why active management is crucial in this landscape

Each year, thousands of people descend on Washington D.C. to attend the meetings of the World Bank and International Monetary Fund. These summits attract a varied crowd, from global policymakers to corporate bosses and investors. Journalists scurry down the corridors hunting for a quote, while anti-globalisation protestors are often to be found wielding placards outside.

At the Autumn Meeting in October, the outlook for global growth and monetary policy will be high on the agenda. But another theme is set to feature as a major talking point across both panel events and confabs on the sidelines: geopolitics.

Geopolitical risk, and its impact on economies and markets, is rising. The period of relative stability that characterised the period after the fall of the Berlin Wall appears to have ended, as evidenced by tensions between major economies such as the US and China, along with outright conflict in Ukraine and the Middle East.

But geopolitics is not just about conflict; it also encompasses shifts in capital flows and the strategic use of capital for political purposes. Experts in international relations describe how the era of Western dominance is giving way to a more fluid, “multi-polar” world.

These trends have significant implications for investors in emerging markets (EM). Higher geopolitical risk can lead to reduced investment volumes, lower asset prices and negative economic outcomes for countries highly dependent on smooth trade flows and access to capital markets.¹ But by monitoring and managing geopolitical risk, investors in EM debt can maintain the resilience of their portfolios and may even be able to spot new opportunities.

Measuring geopolitical risk

Keeping track of geopolitics, with its strategic dimension, its gambits and reversals, can be like watching the movement of pieces across a grand chessboard. But geopolitics is no game, and the stakes could not be higher.

Take the US-China trade war. The tariffs and countermeasures that started in recent years not only had an impact on trade between the two powers, but also affected other economies dependent on them. The semiconductor industry, in particular, with its intricate international supply chains across East Asia, can be particularly affected by changes in trade relations.

Similarly, economic sanctions can lead to capital outflow, reduce nations’ access to international financial markets and negatively impact the value of their debt. The US decision to sanction certain Turkish entities following the Turkish government’s purchase of Russian missile defence system, for example, resulted in significant spread volatility, with spreads on Turkish government debt widening by around 200 basis points over 2018.²

Thankfully, there are ways to assess, contextualise and monitor geopolitical risk. Economists Dario Caldara and Matteo Iacoviello have developed the Geopolitical Risks (GPR) index; this is based on text-search results from decades’ worth of articles in major newspapers, focuses on key terms such as “crisis”, “terrorism” and “war”.

The index starts in 1985 and its two broad components are the  Geopolitical Acts Index and the Geopolitical Threats Index (see Figure 1). These correspond, respectively, “acts” that capture occasions when those threats are realised and to “threats” of military action or terrorism. The index spikes during events such as the Gulf War, the Soviet blockade of Lithuania during the Baltic nation’s battle for independence, the 9/11 attacks and Russia’s invasion of Ukraine.

In order to gauge the historical impact of geopolitical risk and assess the potential impact on spreads in the future, Aviva Investors’ EM debt team plot this index against another, similar index that tracks news headlines relating to economic policy uncertainty across 20 countries, before overlaying the JPMorgan EMBI Global Diversified Sovereign Index spread. This way we can start to see intriguing patterns.

EM debt spreads tend to widen slightly ahead of (or in line with) a geopolitical “threat”, rather than in response to the “act” itself. Typically, there are two peaks: the first occurs when the initial threat emerges, and the second a few months later, depending on the level of economic uncertainty caused by the event or policy, as seen with the escalation of the trade wars between the US and China in 2018.

It’s not surprising that spreads tend to be at their widest during periods of "peak uncertainty". This presents investors with opportunities to capitalise on mispricing in the market, particularly when it comes to identifying stronger issuers whose bonds might have been caught up in the market sell-off, but whose fundamentals are unlikely to be significantly impacted and may therefore stay resilient over the longer term.

Building resilient portfolios

To ensure they are able to monitor these developments and act swiftly to mitigate risks and seize opportunities, investors need both a deep understanding of the political dynamics of the countries in their universe, and the ability to react through active portfolio management.

Grasping the complexities of the modern geopolitical landscape means going beyond simply analysing opinion polls and reading headline commentary. Investors must consider each country within its historical context, assess its current economic and political allegiances, and gauge the aspirations of its citizens. This information, along with more conventional fiscal and economic metrics, can help investors quantify the potential impact of geopolitical events on debt markets and the return profile of particular investments, and come to a view on whether certain risks are worth taking.

Thorough geopolitical risk assessments as part of fundamental analysis will involve monitoring key political developments and evaluating potential scenarios. In-country visits to meet with policymakers and other officials, to understand governments’ reaction functions, can be helpful, as can attendance at international events like the World Bank/IMF meetings, which provide opportunities to meet with numerous decision-makers from key markets. 

Poland exemplifies the extent to which geopolitical risks can become entrenched in a country's outlook and fundamentals. This was brought home on our EM debt team’s recent trip to the country, where being on the ground allowed us to appreciate just how much geopolitics is front and centre in policymakers’ thinking. For Poland, security concerns are existential given the country’s proximity to Russia's ongoing war in Ukraine. That explains why Poland has more than doubled its spending on defence to four per cent of GDP in recent years, higher than the 2-2.5 per cent mandated by the North Atlantic Treaty Organization (NATO). Understanding that geopolitical context becomes crucial when considering the outlook for fiscal, monetary and other macro policies.

As well as doing due diligence at the country level, investors must also consider the broader landscape, including the shifting networks of trade relationships and alliances that have a bearing on countries’ fortunes.

For instance, the United Arab Emirates’ recent decision to provide $35 billion to Egypt as part of a deal to develop real estate on the Mediterranean coast, illustrates a trend for the use of financial resources to strengthen alliances.³ The deal contributed to a rise of more than 30 per cent in the value of Egyptian debt between February and March this year, according to Bloomberg data. 

Similarly, the UAE and India's agreement to settle oil transactions in rupees, though currently modest in scale, signals a growing willingness among nations to transact in each other's currencies, at least within the limits of their trade balances.⁴

Additionally, we are seeing an increasing number of central banks opting to hold non-dollar reserves, particularly in assets like gold. This trend underscores changing trade dynamics and the consequences of rising nationalism. These shifts are making the global landscape more complex, volatile and, ultimately, harder to predict.

Staying active

In order to ensure these geopolitical trends and nuances are reflected in debt portfolios, an active management approach is crucial.

Passive investing is poorly suited to an uncertain and fast-changing geopolitical environment, because benchmark index weightings are often tilted towards countries or companies that have performed well in the past and have historically issued large amounts of debt, often at cheap rates.

The increase in the number of Gulf Cooperation Council (GCC) countries – a grouping that includes Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE – in the JPM-EMBI indices after their inclusion in 2018 is a prime example. While these are among the strongest credits in emerging markets, passively allocating capital to this region at current spread levels may not be prudent.

Meanwhile, countries that are currently smaller constituents of the index may offer more attractive spreads (see Figure 3). And these countries may also, for example, be better placed to benefit from increased demand for gold or shifts in regional alliances over the coming months and years.

Geopolitical risks are dynamic, and the situation in any given country can change rapidly. That’s why it is important to continually monitor geopolitical developments and reassess risk exposure: this may involve rebalancing the portfolio in response to emerging risks or taking advantage of new opportunities based on a real-time analysis of events.

As geopolitical risks become more pervasive and complex, investors must adapt by integrating geopolitical analysis into their investment processes and by moving beyond traditional metrics to account for the shifting dynamics of global power, trade relations and political instability.

By taking an active approach, investors can ensure they are ready to act when the pieces next start to move across the great chessboard.