Geopolitical Risk: How Conflict Moves Markets

Key Takeaways

• The Caldara-Iacoviello GPR Index (2022 AER) measures geopolitical risk from newspaper text counts across 8 categories; a reading of 100 equals the 1985–2019 average.
• First-order reaction to geopolitical shocks: equities fall (cyclicals lead), VIX spikes, Treasuries rally, dollar and CHF are bid, oil rallies if producers are threatened.
• Most geopolitical shocks fade within 1–3 trading days; durable repricing occurs only when the event evolves into a large war or an energy embargo.
• Geopolitics and geoeconomics are distinct: tariffs and sanctions work through supply chains and currencies, not fear premia, and require different portfolio responses.

What It Is

In the academic sense, geopolitical risk is defined by Caldara and Iacoviello in their 2022 American Economic Review paper as "the threat, realization, and escalation of adverse events associated with wars, terrorism, and any tensions among states and political actors that affect the peaceful course of international relations."

Their Geopolitical Risk (GPR) Index is the standard measure in the field. It is built from automated text searches of 10 major newspapers (including the Financial Times, The New York Times, and The Wall Street Journal) counting articles that mention geopolitical tension keywords in eight categories: war threats, peace threats, military buildups, nuclear threats, terror threats, beginning of war, escalation of war, and terror acts. The index spikes around the world wars, the Cuban Missile Crisis, 9/11, the Gulf wars, and major terror events.

The Intuition

Markets price three things in parallel: expected cash flows, a discount rate, and a risk premium. Geopolitical shocks widen the risk premium faster than they change fundamental cash flows. The first-order market reaction is almost mechanical:

• Equities sell off, led by cyclicals
• Volatility (VIX) jumps
• Government bonds rally as investors seek safety
• The dollar and Swiss franc are typically bid
• Oil rallies if producers or shipping lanes are threatened

What makes these events hard to trade is that most fade within days or weeks. Caldara and Iacoviello find that higher geopolitical risk foreshadows lower investment and employment, but the market-pricing effects are often brief unless the event evolves into a durable shock like a large war or an energy embargo.

How It Works

The GPR index is published daily and monthly at policyuncertainty.com and on Matteo Iacoviello's site. Values are normalised so that a reading of 100 corresponds to the 1985 to 2019 average. Spikes above 200 are rare and historically coincide with major conflicts.

Practitioners use geopolitical-risk measures in three ways:

1. Regime overlay. When GPR is elevated and rising, risk models shrink position sizes, widen stop distances, and overweight diversifiers like gold and treasuries.
2. Sector tilt. Durable geopolitical stress favours defense contractors, energy producers, shipping and tanker operators, and cybersecurity. It weighs on airlines, European cyclicals, and EM assets that depend on cross-border capital flows.
3. Event windows. Around specific events (elections, sanctions announcements, missile tests) volatility desks widen implied vol and credit desks demand a higher premium. Option-based strategies often price in an "event premium" that decays after the news passes.

Related but distinct is geoeconomics, the use of economic tools (tariffs, sanctions, export controls, capital restrictions) as instruments of state strategy. Trade wars and sanctions regimes affect supply chains and currencies more than they do direct military variables. Conflating the two leads to sloppy analysis.

Worked Example

Consider the market reaction to the start of the Russia-Ukraine war in late February 2022. On February 24, European equities dropped roughly 4 percent intraday, the VIX jumped from 25 to above 30, Brent crude rallied toward $105, gold popped above $1,970, and the dollar was broadly bid while the euro fell.

A short-horizon risk-off trade would have worked in the first 48 hours. Then markets stabilised, and by mid-March most US equity indices had recouped losses despite ongoing conflict. The durable winners over the following 6 to 12 months were energy and defense, not broad safe havens. A trader who stayed short European equities on the original thesis underperformed a trader who rotated to energy and defense after the initial spike.

This pattern (fast initial reaction, partial reversal within days, durable sector re-pricing) is typical of geopolitical shocks that do not escalate into direct great-power conflict.

Common Mistakes

1. Treating headlines as tradeable signals. Most geopolitical headlines fade within one to three trading days. Buying gold or shorting equities on a single news spike is usually a losing trade after costs and slippage. Wait for evidence of a durable regime shift before re-positioning heavily.

2. Conflating geopolitics with geoeconomics. Tariffs and sanctions are economic weapons and work through supply chains and currencies, not through fear premia. A tariff announcement may barely move the VIX while rotating entire sector leadership. Use the right framework for the right risk.

3. Underweighting sector spillovers. Broad equity indices often recover faster than specific sub-sectors. A war in a gas-exporting region can dent European chemicals and fertilisers for quarters, while the S&P 500 looks fine within weeks. Position at the sector level, not just the index level.

4. Over-reacting to commentary versus actual policy. Hearing a defense minister threaten a response is not a policy change. Markets discount signalling heavily. Wait for concrete actions (sanctions lists, military deployments, formal declarations) before treating a development as a step-function risk.

Frequently Asked Questions

How is geopolitical risk measured? The standard academic measure is the Caldara-Iacoviello Geopolitical Risk (GPR) Index, published in the 2022 American Economic Review. It counts newspaper articles across 10 major publications that mention geopolitical tension keywords in eight categories including war threats, military buildups, nuclear threats, and terror acts. A reading of 100 equals the 1985–2019 average; spikes above 200 are rare and coincide with major conflicts.

How does a geopolitical shock typically move markets? The first-order reaction is mechanical: equities sell off (cyclicals lead), VIX spikes, government bonds rally as investors seek safety, the dollar and Swiss franc are bid, and oil rallies if producers or shipping lanes are at risk. Most of this repricing happens within hours and partially reverses within days unless the event escalates into a durable structural shift.

How long do geopolitical risk premiums last? Most geopolitical shocks fade within one to three trading days. Caldara and Iacoviello find that elevated GPR foreshadows lower investment and employment on a 6-month horizon, but the market-pricing effects are brief unless the event evolves into a large war or an energy embargo. The Russia-Ukraine war example: US equity losses from February 24, 2022 were largely recouped by mid-March, but energy and defense outperformed for the following 6–12 months.

What is the difference between geopolitical risk and geoeconomic risk? Geopolitical risk involves military threats, wars, and state-level conflict. Geoeconomic risk uses economic tools, tariffs, sanctions, export controls, capital restrictions, as instruments of state strategy. They affect markets differently: geopolitics moves volatility and risk premia; geoeconomics rotates supply chains and currencies. Conflating the two leads to sloppy portfolio positioning.

Which sectors benefit from prolonged geopolitical stress? Defense contractors, energy producers (when supply routes are threatened), shipping and tanker operators, and cybersecurity companies tend to outperform during durable geopolitical stress episodes. European cyclicals, airlines, and EM assets that depend on cross-border capital flows tend to underperform. The initial broad risk-off trade reverses faster than the sector re-pricing in affected industries.

Sources

1. Caldara, D. and Iacoviello, M. "Measuring Geopolitical Risk." American Economic Review, vol. 112(4), pp. 1194-1225, 2022. https://www.aeaweb.org/articles?id=10.1257/aer.20191823
2. Caldara and Iacoviello. "Geopolitical Risk (GPR) Index." https://www.matteoiacoviello.com/gpr.htm
3. Caldara and Iacoviello. "Measuring Geopolitical Risk" (working paper PDF). https://www.matteoiacoviello.com/gpr_files/GPR_PAPER.pdf
4. World Bank. "Geopolitical Risks and Trade." https://documents.worldbank.org/en/publication/documents-reports/documentdetail/099257009232525631

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.