Against Cassandras: World War III

When it comes to doom and gloom prophecies, nothing has gained as much traction in the last two years as prophecies of World War III. Or rather, any kind of prophecy of a geopolitical crisis. Throughout most of 2022, the merchants of doom and gloom were worried about Putin using nuclear weapons in Ukraine or attacking a NATO member country thus forcing the US and other NATO member states to enter a shooting war with Russia.

When it comes to geopolitics, most people think about geopolitics in the narrow sense of war, civil war, and terror acts. And many investors think that these things matter for their portfolios. In fact, an army of geopolitics advisors is making good money from consulting financial services firms on geopolitical risks.

These geopolitics consultants typically talk about all the things that can go wrong in the world of international affairs. I have never heard a geopolitics expert whose thesis was: “You know what, we are going to be all right. Yes, we have some problems, but we will muddle through and in the bigger scheme of things, they really don’t matter.”

Why is that?

(And please, if you can find evidence of a geopolitics expert being optimistic leave a link in the comments section)

In any case, Cassandras that deal in geopolitical risks have long been a bugbear of mine. So much so that I sat down and wrote an entire book about geopolitics for investors which you can download for free at the CFA Institute Research Foundation.

One of the key messages was that most of the time, geopolitical events do not matter for investors. In the introductory post of this series, I show the long-term chart of US and UK equity markets. As I said back then, you will not be able to find the Vietnam War, Afghanistan or the Iraq Wars, September 11, or other geopolitical events in this chart. They simply don’t matter, or at least they don’t matter for more than a few days or weeks.

That is, of course, until they do. The Russian invasion of Ukraine did matter for equity markets. But it did not matter because of the war, but because of the impact it had on energy prices and in particular natural gas prices. This brings me to the second key message of my book. Learning how to identify which geopolitical events matter and which ones don’t is key to being successful as an investor.

And this is where Cassandras who predict geopolitical crises always fail. To give you an idea of what I mean let us take a look at the Geopolitical Risk Index by Dario Caldara and Matteo Iacoviello. This index is based on news reports about geopolitical events like wars, civil wars, terror attacks, etc., and thus gives you an idea of how publicly visible the Cassandras who predict doom and gloom are.

Geopolitical Risk Index

Source: Caldara and Iacoviello (2021)

Looking at the index since 1985 the major spikes indicate the US war against Iraq in 1991, the September 11 terrorist attacks in 2001, and the start of the Iraq Wart in 2003. Finally, the last major spike was the Russian invasion of Ukraine in 2022.

Now, let’s take this index and compare it with the performance of the stock market.

Geopolitical Risk Index and the S&P 500

Source: Bloomberg, Caldara and Iacoviello (2021)

Clearly, the Russian invasion of Ukraine triggered a bear market, but in the case of 9/11 or the 1991 invasion of Iraq, you have to squint your eyes to find any impact. And in the case of the start of the Iraq War in March 2003, that was literally the day when the multi-year bear market ended and a new bull market began.

But that’s just an optical assessment of the correlation (or lack thereof) between geopolitical events and stock markets. In my book, I go into much more detail and show under which circumstances geopolitical events matter (because sometimes they do), but here, I want to do a simple analysis that shows you why simply listening to Cassandras who predict geopolitical crises is a bad idea.

If you look at the correlation between the Geopolitical Risk Index and the monthly return of the S&P 500, you will find it is practically zero (or -0.06, to be precise). The correlation between the Geopolitical Risk Index and the performance of the S&P 500 in the subsequent month is also zero (or +0.01, to be precise). So, blindly following geopolitical risks no matter how big or small is the same as trading based on noise. There is no signal there.

But what about the bigger spikes in the Geopolitical Risk Index?

Let’s assume that you are able to predict which events are major events (and not even professional diplomats can do that in real-time as I have discussed here). If I restrict my analysis only to the 5% largest spikes in the Geopolitical Risk Index the correlation with the S&P 500 in the same month is -0.16 and with the S&P 500 in the following month is +0.05. In other words, not even one in twenty geopolitical risks matters for the stock market.

I like to quip that nine out of ten geopolitical events don’t matter to investors, but the tenth does. Looks like I must revise that…

In any case, what this shows is that listening to geopolitical forecasts of doom and gloom is a bad idea for several reasons:

• Most geopolitical threats never escalate into wars or other geopolitical crises. Hence, listening to Cassandras talk about geopolitical threats is destined to bring up many more false alarms than true signals.

• Even if a geopolitical event escalates, an investor must be able to correctly separate the major events from the ones that don’t escalate to major events as these events unfold in real-time.

• And if it turns out to be a major geopolitical event, key drivers of asset return like inflation, risk-free rates, or future cash flows must be permanently and materially altered to make an impact on the portfolio.

Henry Kissinger once said that university politics is so vicious because the stakes are so low. Turn that around and you understand why most predictions of geopolitical crises can safely be ignored: The stakes are enormous when it comes to geopolitical crises. Thus, the most likely course of action is to stop escalating before it is too late.

As I said in my introductory post of this series: We rarely fall off a cliff. And investing based on the assumption that we will fall off a cliff is going to lose you money.

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Previous instalments of this series:

• The US Dollar

• Interest rate normalisation

• The government debt bomb

• Inflation

• The Euro