In brief
- Media focus on geopolitical risk may feel extreme but the geopolitical risk index (GPR)1 is only slightly above its long-term baseline.
- Still, political polarization is elevated, potentially frustrating consensus building and risking events escalating quickly.
- Geopolitical tension does not always overlap with market stress, but it can affect economies either by damaging confidence, and demand, or by disrupting supply chains.
- We favor bonds to protect portfolios from growth shocks and real assets to protect from inflationary risks. We note that a balanced portfolio is favorable to hiding in cash even during periods of heightened tension.
In five short days, we’ve witnessed an Oval Office encounter with more theater than anything Hollywood could dream up, a show of European unity that transcended post-Brexit mistrust, and a “tariff Tuesday” where Canada, China and Mexico found themselves on the sharp end of newfound U.S. enthusiasm for tariffs. Little wonder investors are asking us about geopolitical risk. While geopolitical tension surely drives headlines, it doesn’t necessarily drive markets – separating media hyperbole from market impact is crucial.
A cool-headed analysis of geopolitical risk should ask three questions:
- Are risks elevated compared to history?
- Are those risks driving markets today?
- How are investors responding to those risks?
In our view, geopolitical risk is slightly elevated but far from extreme. Nevertheless, political polarization has intensified and creates a more febrile environment. Investors are paying to protect portfolios, but equally they fear missing out on the upside should the narrative shift from tariffs to tax cuts or should a palatable path to peace emerge for Ukraine.
The Geopolitical Risk Index (GPR)1 highlights two important patterns. First, geopolitical risk is noisy and modest spikes in the index are common. Second, major spikes in tension associate primarily with outbreaks of war. The Russian invasion of Ukraine in 2022, and Chinese military maneuvers around Taiwan in 2023 caused the most recent spikes, but today the index is only slightly above its long run baseline.
We can look at geopolitical risk differently –questioning instead the potential for events to spiral out of control. The populism index2 shows that as of 2023 more than a quarter of voters were selecting extreme parties. If we consider the various European election results from 2024 and the German election in February 2025, that share approaches 30%. The increasing presence of radical parties can frustrate the process of consensus building and may create an environment where issues escalate more rapidly.
A more challenging political backdrop could be a reason for caution even if the geopolitical risk index is subdued. But the VIX index that is a proxy for market tension is poorly correlated to the geopolitical risk index. Sometimes events coincide, but some of the biggest routs in market history, such as the global financial crisis and the pandemic coincided with periods of geopolitical calm. It is the economic impact of geopolitical tension that can roil markets – not simply the rhetoric.
Even with the geopolitical risk index subdued, investors do appear to be responding to the challenging investing environment. As of the end of February, the relative price of protecting an equity portfolio with puts was in its 76th percentile3, implying that investors are paying up for “insurance.” Interestingly, however, the price of positioning for upside with calls and buying puts to protect the downside had reached its 67th percentile4. While investors want to hedge the downside, possibly triggered by geopolitical tension, they also fear missing out on the upside should events break positively.
Building portfolio resilience
For balanced portfolios and investors unable to turn to the options market, much can be done to build resilience. Geopolitical tension can spill into economies in two ways: denting confidence and demand, leading to a negative growth shock, or disrupting supply, in turn risking an inflation shock.
Recent price action in U.S. Treasuries shows that bonds continue to provide good returns as growth expectations moderate. In the event of a growth shock and a 200bps fall in rates, U.S., UK, and German government bonds could see returns of around 20% – potentially insulating equity portfolios from a drawdown associated with lower growth expectations. By contrast, during the inflation shock in 2022, real assets such as timber, infrastructure, and transportation delivered positive returns, even as the 60/40 stock/bond portfolio suffered its worst drawdown since 2008.
Simply put, we favor bonds for growth shocks, real assets for inflation shocks, and an active stance for the journey.
Finally, some investors feel that cash offers a good place to hide from geopolitical risks. To test this assumption, we looked at 12 major market shocks since 1990 to assess how cash returns compare to a 60/40 stock/bond returns. To ensure we set the bar high, we assumed that we invested the month before the negative shock took place. The result is stark. After one year, the 60/40 beats cash 75% of the time by an average of 7%. After three years, the 60/40 beats cash on all occasions by an average of 21% (Exhibit 1).
Whatever your view of geopolitics today, data show that acute tension is lower than the media would have us believe. But even if we are in a more febrile environment, hiding in cash is not a winning strategy. Old wisdoms endure for a reason: it is time in the market, not timing the market, which wins in the long run.