Why geopolitics matters for investments? And how?

Recent unprecedented geopolitical risks (GPR) are creating a very unfamiliar and uncertain landscape for global investments and investors. The global effects of geopolitical risks are being faced by not only the major countries but also by the smaller Emerging Markets and Developing Economies. Geopolitical events of the recent past have affected growth, trade, economic fragmentation (contra to economic integration), stock returns, bond yields, sovereign risk premia, currencies, commodity prices and the role of the dollar as a reserve currency. These in turn affect asset allocation. Whilst all countries are affected by increased GPRs, the magnitudes and timings of the effects are different. We think that all investors ought to consider GPRs, since these influence both the returns and risks of a portfolio. 

More than three decades ago, late Professor Sam Huntington of Harvard wrote the epic “The Clash of Civilizations: the making of a New World Order”. He argued that wars would be a clash of cultures rather than a clash between countries. The late Henry Kissinger called it the best book on international affairs post the Cold-War. Huntington’s book laid out the thesis for a Changing World Order highlighting China, Russia vs Crimea, the Muslim Youth Bulge in the Middle East and Africa, the potential decline of the US and its influence. Huntington’s ideas were considered controversial too as few considered his theory to be simplifying and ignoring some realistic interdependencies.  

Erik Reinfeldt, former Swedish PM (at the 2024 IPE Annual Conference, Prague) spoke about the implications of the new “strong man culture” in global political leadership and its implications for Europe. In “The Crisis of Democratic Capitalism” Martin Wolf addressed why the relationship between democracy and capitalism is coming unstuck. He stated that the failings of democratic capitalism have resulted in slower growth, increasing inequality and widespread disenchantment with current regimes. At the end of the Cold war, it was thought that freedom-political and economic- had won relative to totalitarianism and authoritarian regimes. But nearly three and half decades later, neither liberal democracy nor capitalism are strong and victorious today. But Wolf maintains that democratic capitalism remains the best system for the world.  

To quantify geopolitical risks, the Geopolitical Risk Index (GPRI) was created by Caldara and Iacoviello (2002) by tracking newspaper coverage of geopolitical tensions which included nuclear threats, war threats, peace threats, war escalation, terror events. The GPRI captures the realization as well as perception of risks that matter for asset prices.  

Figure 1 below illustrates a 40-year history of geopolitics risks during major events and shows that the GPRI has increased over the last 4-5 years with increased military build-ups, beginning of wars etc. Figure 2 shows increased Financial and Trade Sanction

Source: IMF, Caldara, Dario and Matteo Iacoviello (2022), “Measuring Geopolitical Risk,” American Economic Review, April, 112(4), pp.1194-1225. Data dwonloaded from https://www.matteoiacoviello.com/gpr.htm on 19 Jan 2026

Source: IMF

In addition to the above, there has been an increase in the share of countries increasing their military expenditures. The important question to ask is how do geopolitical events influence asset prices—or technically the transmission mechanism of GPR on to asset prices. As Figure 3 shows, it is mainly through market sentiment and economic fundamentals.  

Source: IMF

Gita Gopinath (2024), formerly of the IMF, highlighted the fact that the global economic landscape is being transformed in ways different from the earlier post-World War 2 world with multilateral rules framework and institutional structure. She shows that trade restrictions across goods, services and investments have tripled and financial sanctions have increased. She states that geopolitical blocs—pro-China, pro-US, and neutral—are shaping trade and investment in an increasingly fragmented global economy. Gopinath argues that while the current economic fragmentation is similar to the initial Cold War period, it is likely to be much costlier today due to a higher share of trade to GDP (~46%). She finds that geopolitics has not yet affected the dominant role of the USD in both Trade Finance (80%) and as a Reserve Currency (~60%). The IMF’s Managing Director Kristalina Georgieva cautioned that geopolitical fragmentation could reduce global GDP by 7% in the long-term.  

A Mattoo, M Ruta and R Staiger (2024) study Geopolitics in the context of US-China rivalry and the current diminished status of the WTO. The current heightened geopolitical rivalry seems to have undermined the WTO. They state that the WTO’s relevance is in question only if it adheres too rigidly to its existing rules and norms. It can continue to thrive as a forum for multilateral trade cooperation if it adapts in a measured way to current geopolitical strains.  S Aiyar, D Malacrino and A.F Presbitero (2023) assess the role of geopolitical alignment in Foreign Direct Investment (FDI) flows testing whether friendshoring helps to lessen the impact of geopolitical tensions. They show that slowbalization (slowdown in globalization, post GFC) resulted in FDI declines from 3.3% of GDP (2000s) to 1.3% (2018-2023). They state that while many factors like automation and technological change could be responsible, the emergence of fragmentation of capital flows along geopolitical lines and potential emergence of regional blocks are newer factors.

IMF Research (GFSR April 2025) showed that average stock market returns responded to post WW2 geopolitical events as in Figure 4 below. The average monthly drop in stock prices is 1% across countries, but a much larger 2.5% stock price decreases in EM economies. 

While we show the impact on two major equity market return indices, it is interesting to ask how GPR affects countries and assets? Does it vary across countries and regions?  

Table 1 below answers that question by displaying the average weekly cumulative  changes in asset prices.  It shows the differences across advanced economies, emerging markets and developing economies (EMDEs), commodity exporters and commodity non exporters too. Commodity-importing countries tend to suffer more, whereas commodity exporters often experience positive stock returns after major geopolitical risk events. Tariff announcements by the US and China between 2018 and 2024 negatively impacted stock prices; following US announcements, Chinese firms saw nearly a 4% decline. But some tariff announcements affected stock returns by up to 8% as in May 2019.  

IMF (2025 GFSR) record that aggregate stock prices across economies have generally declined in the immediate aftermath of major global geopolitical risk events. Although on average the impact has been moderate (3%), but some events have caused a substantially larger negative impact across countries. Severe geopolitical shocks (those 2 standard deviations above the mean) can have persistent and large effects on stock prices. They state that “a typical geopolitical risk shock has an impact about three times as large, and a large geopolitical risk shock has an impact about 20 times larger, than the average stock market return”.   

The Geneva Report 28 (2025) re-examines the impact of the recent rise in geopolitical fragmentation on the international financial landscape, the potential repercussions of further fragmentation, and the policy measures that could avert or mitigate its economic consequence. The benefits of growing international financial integration (contra to fragmentation) since the 1980s are widely known. While measures to strengthen resilience can reduce vulnerabilities to external shocks, geoeconomic fragmentation would adversely impact allocative efficiency, disrupting international risk sharing, weakening the global financial safety net, hampering international coordination and financial responses when crises occur. Geopolitical tensions increase the frequency of real and financial shocks and through transmission mechanisms raise the cost of external finance, particularly for more financially vulnerable countries. 

This para summarises the views of the Geneva Report authors. At the end of 2013, the Russian economy was becoming increasingly integrated with global financial markets. Benefiting from high oil prices, Russia was running substantial current account surpluses, which made it a net creditor vis-à-vis the rest of the world, despite an undercount of asset accumulation by residents abroad due to historically large capital flight. This pattern changed sharply starting in 2014. Foreign financial inflows into Russia remained very modest in subsequent years, as Russian policymakers sought to increase financial autarky, including by repaying a sizeable portion of external debt (declined by over $200 billion between 2013 and 2015). In subsequent years inflows remained very low – total external liabilities at the end of 2020 were some $300 billion below those at the end of 2013. Financial claims increased with a rapid buildup of foreign exchange reserves, which exceeded $600 billion by the end of 2021. During this period the foreign exchange reserves composition changed sharply, with the share of the euro and the dollar falling and the share of gold and the renminbi rising.  

The figures below which illustrate the extent of international financial integration (as a percent of global GDP) show how dominant the US and countries geopolitically close to US are in global finance (~ to 65%) whereas China and Chinese geopolitical allies accounted for 3%. By way of comparison, China accounts for 15% global GDP and 13% of global trade