The International Monetary Fund (IMF) has found investment markets tend to price-in some geopolitical risks but regularly fail to incorporate the long-term impact of major shocks such as war.
According to the IMF study included with its just-released global financial stability report, investment markets have mostly shrugged-off an almost uninterrupted series of global conflicts dating back 40 years.
However, the analysis of market reactions to 450 “major geopolitical risk events” between 1985 and 2024 shows investors may have been too blasé about the long-term effects of some serious international conflagrations.
“Overall, investors seem to factor geopolitical risk into both equity and options markets. However, surprise realizations of geopolitical risks can still lead to sharp asset price corrections and increased financial market volatility, potentially impacting investors and financial institutions…,” the IMF report says.
“… These results suggest that major geopolitical risk events can trigger large and persistent corrections in asset prices, generating market volatility that could threaten macrofinancial stability.”
While investors easily absorb baseline global tensions, large geopolitical shockwaves tend to reverberate through share markets over longer periods in a scaled-up fashion.
The IMF study found aggregate equity indices typically fall by about 0.3 per cent in the wake of a country-specific event in an effect that persists for at least two years.
“However, more severe geopolitical risk shocks—that is, shocks that increase the geopolitical risk index by at least two standard deviations beyond its mean—have an effect about 7 times larger and are notably persistent.”
A run-of-the-mill geopolitical shock in the IMF sample had a negative impact on share indices about three-times the average 0.1 per cent quarterly return of stock markets while major global events skewed performance down 20-times compared to the same metric.
During the 40-year period covered in the study, roughly one-sixth of the 450 major geopolitical flare-ups were “international military conflicts”.
“… others involve diplomatic tensions, domestic political unrest, terrorism incidents, or the announcement and implementation of trade restrictions,” the report says.
IMF authors Salih Fendoglu, Mahvash Qureshi and Felix Suntheim note that geopolitical shocks usually infect investment market conditions for months.
“Investors, however, recognize these risks and demand compensation for holding stocks that may perform worse when hit by a shock.
“Eventually, a sudden drop in asset prices may weigh on bank and non-bank financial institutions with potential spillovers to the broader financial system and the real economy. For example, banks tend to curb lending, and investment funds face lower returns and elevated redemption risk when exposed to geopolitical risk events.”
The wider IMF report says global financial stability risks have “increased significantly” amid high asset valuations in key markets, rising financial institution leverage that could spill over to the banking system and sovereign debt “challenges”.