How do geopolitical shocks impact markets?

But what is the connection between geopolitical concerns and market returns? It’s not always easy to discern.

In this article, we explore the nexus between geopolitical events and their market impact, analyzing over 80 years’ worth of data. We find that geopolitical events usually have no lasting impact on large cap equity returns.

However, geopolitics can have profound market impacts at the local level. We look at three examples: small cap German stocks; Hong Kong versus Singapore real estate values; and shifting dynamics in the gold market. Gold, we note, has historically been one of the best-performing tactical hedges against geopolitical risk.

In a separate and final section, we examine the growing economic and political power of the BRICS economies. The BRICS traditionally referred to Brazil, Russia, India, China and South Africa, but the bloc now includes Egypt, Ethiopia, Iran and the United Arab Emirates (known as BRICS+). We consider the possibility of a G7 versus BRICS+ divide and what that might mean for the U.S. dollar as the world’s global reserve currency. 

History lessons

Our tally of significant geopolitical events, shown below, begins with Germany’s invasion of France in 1940, and ends with Russia’s invasion of Ukraine in 2022.

The 1973 oil shock did have a lasting impact on equity returns. That is mainly because oil remained in short supply for an extended period, resulting in a macro state of “stagflation” (high inflation amid deteriorating productivity growth). In other words, high oil prices essentially stopped the economy from operating efficiently in the 1970s. In contrast, after Russia’s invasion of Ukraine shocked global energy markets in 2022, additional oil supply rapidly came on stream. As a result, the economic and market impact of the recent shock was less severe and sustained than its 1970s counterpart.

The main structural difference between the two episodes relates to U.S. oil production. In the 1970s, the United States was producing as much oil as it could with the technology available at the time. Thus the United States relied heavily on oil produced in the Middle East. Today, by contrast, production is flexible and U.S. oil is generally plentiful thanks in large part to the boom in shale fracking.

Geopolitical shocks can hit local markets hard

Still, we don’t think investors can completely ignore geopolitical shocks. While the data shows that geopolitical events generally don’t have enduring impacts on large cap (globally diversified) equity markets, the story is very different at the local level, as we discuss with a few topical examples in the following section.

German small cap versus large cap companies

Global equity markets have essentially shrugged off the risks associated with the war in Ukraine (a significant geopolitical event by any definition). But the shock itself has led to a collapse in Europe’s manufacturing competitiveness, due to substantially higher energy costs (as Europe broke its link to Russian energy in the wake of the 2022 invasion). Germany has been especially hard hit.

Meanwhile, compared with German small caps, large cap companies are more diversified globally and have a higher weighting to the technology sector and a lower weighting to energy-intensive sectors such as industrials and materials.³ As a result, large caps have better managed the challenges facing the German economy as a result of the war in Ukraine.

Hong Kong versus Singapore real estate

The changing geopolitical dynamics between China and Hong Kong in recent years have had a chilling impact on real estate values—and the economy more generally—in Hong Kong. The result: a widening gap between real estate values in Hong Kong and Singapore.

Geopolitics has shaped the market backdrop. As a result of a series of events in Hong Kong, including a 2019 protest and the enactment of the National Security Law in 2020, it is widely believed that China has tightened its grip on Hong Kong. And since 2019, observers have noted a wave of population outflows from Hong Kong to alternative locations such as Singapore, Canada and the United Kingdom.⁴

Hong Kong’s total population declined by 2.2% from 2019 to 2022. More dramatically, the younger part of Hong Kong’s labor force (people aged 15–29) has contracted by nearly 25% as of March 2024.

A shrinking population along with concern about the future and corporate de-risking have accelerated the downturn in the Hong Kong property market. This has led to a widening gap between real estate values in Hong Kong versus Singapore, a key destination for people leaving Hong Kong. As illustrated in the chart below, from 2019 to the present, real estate values in Singapore have risen more than 30%, but in Hong Kong they have dropped nearly 20%.

To be sure, Singapore’s real estate market was always undervalued relative to Hong Kong’s, so a convergence was likely to happen in the long run. But the abrupt shift in recent years likely reflects political developments in the region.⁵

Shifting dynamics in the gold market

Historically, gold prices have shown an inverse relationship with real yields on U.S. Treasuries (i.e., inflation-adjusted interest rates). For example, when real yields declined, gold appreciated in value (and vice versa). As gold itself does not generate income, real yields could be seen as the opportunity cost for owning the asset. 

But changes in U.S. Treasury real rates no longer drive gold prices. The historical relationship has been largely irrelevant since 2022. The reason: geopolitics. 

The United States and its allies froze Russia’s foreign exchange reserves after the outbreak of war in Ukraine. Most of Russia’s reserves were held in U.S. dollars, and those reserves were unable to be used in a time of stress—a profound change in modern warfare. Since then, global central bank demand for gold has more than doubled as a percentage of overall demand. Central banks are diversifying toward gold, irrespective of the real interest rate backdrop, as gold is seen as “unsanctionable.”⁶

An analysis of high-frequency gold price dynamics is revealing. Although, as we’ve discussed, geopolitical shocks typically don’t have a lasting impact on global equity markets, these shocks can lead to near-term drawdowns in both stock and sovereign bond prices. Gold has typically been an effective hedge against such short-term volatility—in fact, it is one of the best tactical hedges against geopolitical risk that we are aware of.

The chart below illustrates that in the window leading up to and including a geopolitical shock, gold has typically been the best tactical hedge (although oil and the U.S. dollar have also usually worked to a lesser extent).^{7, 8}

What this means for your portfolio

As our analysis suggests, some concerns about the market impact of geopolitics are overstated. But investors cannot ignore geopolitics. While history shows that geopolitical events do not have lasting effects on globally diversified equities, the impact on local markets can be substantial.

Are your investments highly concentrated in specific markets (e.g., is your wealth concentrated in the equity you hold in a small business)? If so, you may want your assets to be more globally diversified. For investors who would like to mitigate the short-term volatility that can come from geopolitical shocks, it may make sense to add exposures to gold and oil as portfolio hedges.

What about the BRICS+?

At this juncture, we pivot to a discussion of the growing geopolitical influence of the BRICS+ economies. It’s an evolving story.⁹

We quantified the growing geopolitical influence of the BRICS+ vis-à-vis the G7 economies in the table below. It includes various “geopolitical power” metrics such as population size, resource production and advanced manufacturing output.

Clearly, the BRICS+ are growing in strength and power—even as they lack a common currency. The U.S. dollar remains entrenched as the world’s global reserve currency, and even the BRICS+’s most powerful economy, China, has made little progress in making its currency, the RMB, more internationally held as a reserve currency.¹⁰

The chart below illustrates the dominance of the U.S. dollar across key metrics, including foreign exchange holdings by central banks and other official institutions, international lending and global currency payments.

We also examined the liabilities of the BRICS+’s multilateral development bank, the New Development Bank (NDB), which is the BRICS+ analog to the World Bank. We found that the NDB is heavily attached to the U.S. dollar: Nearly 70% of its outstanding loans are made in U.S. dollars versus just under 20% for the RMB.¹¹

To diversify their reserve holdings, the BRICS+ economies have been heavy buyers of gold in recent years. In 2022 and 2023, more than 50% of net global official gold purchases were made by BRICS+ institutions.¹² There are even anecdotal accounts that gold is being used to settle excesses in growing local currency trade between BRICS+ members.

We don’t expect the U.S. dollar to lose its dominant role in the global economy and financial system anytime soon. But there are longer-term—and unresolved—questions about the U.S. fiscal deficit (as we wrote about last fall). Clearly, too, the fact that the U.S. dollar is the global reserve currency allows U.S. citizens to live beyond the means of their country’s production capabilities.

To illustrate this phenomenon, the chart below plots current account balances versus average incomes. The assumption is that growth can be “constrained” by a country’s ability to grow its exports in line with GDP.¹³

As the chart underscores, the United States is an extreme outlier in the global economy. With the trendline plotted, we can calculate how much U.S. living standards (i.e., average daily incomes) would need to fall if the U.S. dollar were to hypothetically lose its reserve currency status. The decline would be catastrophic— about a 50% drop in living standards.

As we’ve said, we expect the U.S. dollar to keep its status as the world’s reserve currency for the foreseeable future. But the exercise does remind us that when a single nation’s currency dominates the global financial and trading system, imbalances may be inevitable. John Maynard Keynes warned of these imbalances when the international monetary system needed to be reconstructed in the wake of World War II.¹⁴

We can help

Geopolitics can be a difficult subject. Your J.P. Morgan team can offer their perspective on how to evaluate the relevant risks and opportunities, as well as what portfolio changes—perhaps including added exposure to gold—might help you hedge geopolitical risk and achieve your financial goals.

¹We also performed robustness tests controlling for the trend in equity prices before a geopolitical shock occurred, and the same general pattern of results held. And, while our main result is showing average returns, we also ran the analysis on median returns, which similarly didn’t change the general pattern of the results. These robustness test results are available on request.

²There are other geopolitical shocks in our dataset that resulted in a negative 12-month real return for equities; however, they tend to be correlated to the business cycle, which was likely the more important driver of returns (e.g., Russia invading Georgia in 2008) rather than the geopolitical shock itself. In our view, the 1973 oil shock is the cleanest example of a geopolitical shock doing lasting damage to equity market returns.

³For the large cap segment in Germany, the respective sector weights for technology, industrials and materials at the start of 2022 were 15.5%, 17.0% and 5.5%, respectively, whereas for small caps, the same respective sector weightings were 14.0%, 26.8% and 10.3%.

⁴Another factor influencing population outflows from Hong Kong is that Hong Kong experienced much harsher COVID lockdowns than other economies, including Singapore. We confirmed this via the Stringency Index produced by the University of Oxford.

⁵Here is a peculiarity of Singapore’s real estate: 80% of public housing isn’t actually affected by foreigners entering. Foreign buying has been concentrated at the top of the private market, namely homes above $5 million.

⁶This is the perception, but it is not entirely true, particularly if the gold is held away in foreign jurisdictions.

⁷After the peak fears surrounding a geopolitical shock fade, gold and oil tend to give back some of the gains. But in a sense, this is just making an obvious point, which is that portfolio hedging surrounding a geopolitical shock is something that needs to be actively managed.

⁸We even analyzed the geopolitical hedge properties of bitcoin, and while it performs decently as a tactical geopolitical hedge, the performance isn’t as strong and reliable as gold’s. Results available on request.

⁹Argentina recently left the BRICS, but Colombia has recently expressed interest in becoming a member of the bloc. https://foreignpolicy.com/2024/04/26/argentina-nato-colombia-brics-brazil-lula/

¹⁰Furthermore, China has a mostly closed capital account; if capital can’t flow freely in and out of the country, it severely limits the ability of the RMB to function as a global reserve currency.

¹¹The NDB is also much smaller than the World Bank in terms of its lending capacity. The NDB currently has about $33 billion of loans outstanding compared to $253 billion by the World Bank. https://www.ndb.int/wp-content/uploads/2023/12/NDB_AR_2022_complete-1.pdf

¹²Which may be an understatement, considering that Iran’s purchases are not widely monitored.

¹³A relationship known in the academic literature as “balance of payments constrained growth.”

¹⁴Specifically, Keynes proposed the idea of a supranational currency called the “bancor” as part of the Bretton Woods negotiations after World War II. He believed that having a global currency managed by an international authority would prevent the imbalances and economic instability that can arise when one nation’s currency serves as the world’s reserve currency. Keynes was wary of the dominance of any single currency, as it could lead to economic hegemony and power imbalances among nations. However, his proposal for the bancor was not adopted, and the U.S. dollar became the world’s primary reserve currency under the Bretton Woods system.