Stress Testing Investment Strategies With Two Geopolitical Scenarios

Geopolitical risks from global conflicts have drawn more attention from investment professionals in recent years due to the implications for economies and financial markets.

In this article we present two broad geopolitical scenarios and discuss how to use them in stress tests to analyze possible impacts on investment strategies. They serve as a starting point that you can build upon with additional assumptions relevant to your situation. For your convenience, we added the scenarios as default Thematic Scenarios in the Portfolio Analysis Stress Testing report in the FactSet Workstation.

Geopolitical fragmentation and geopolitical tension

As a start we would present the difference in the assumptions of the two groups of thematic stress tests added:

Scenario No. 1: Geopolitical fragmentation intensifies 

Based on increased geopolitical risk, wars, conflicts, and political decisions, there is a division (or threat of division) of trade and economic activities along geopolitical borders. Examples include:

• The trade restrictions against Russia after the invasion of Ukraine (Feb-March 2022)

• Brexit Referendum (June 2016)

• Possible Greece exit from EU (May 2012)

These scenarios have a perspective that is usually longer-term in nature, such as a month or so, as the restrictions/barriers take time to establish themselves. The values set in the scenarios are based on observations on how markets (equity prices and market volatility, corporate bonds, crude oil) responded to the above-mentioned historical events. Those scenarios imply:

• Equity market drops by 7%

• Volatility index spikes by 30%

• Corporate spread increases by 15%

• Crude oil price increases by 10%

Scenario No. 2: Geopolitical tension increases 

These are situations when conflicts in different parts of the world spark or intensify, such as the Gaza conflict in October 2023 and again in April 2024. They are typically shorter in terms of response of the markets, such as a few days after the conflict sparks, thus representing the initial reactions to the event.

The shocks included are based on the analysis of the European Central Bank on the geopolitical risk impact on financial markets from May 2024. These scenarios assume:

• Equity market drops by 1%

• Volatility index spikes by 1.5%

• Corporate spread increases by 3%

• Crude oil price increases by 10%

Together, both scenarios are defined as the stressed returns of major market representative indices, serving as predictors in the model analysis. Conditional on the assumed returns above, the model will calculate the respective returns of all risk model factors—for example, rates, equity sectors, spreads—and propagate the shocks on both the asset and portfolio levels.

Regional and global perspective

For additional precision with multi-regional funds, we provided separate shocks for the US, EU, UK, Canada, and global. For example, for a US focus in scenario No. 1 (geopolitical fragmentation intensifies) we applied a shock on US-based equity and credit spread indices to ensure the impact of US markets will be more precisely captured than it would be if using world indices.

Likewise, for a global focus we shocked a representative global index on equity, credit spread, and volatility (instead of multiple regional indices per each sector). Alternatively, when we shock multiple equity regional indices—for example, to represent the equity markets shock—we risk that statistically unstable returns could be calculated for the rest of the factors and assets, as regional equity markets are correlated.

Stress test analysis

Our analysis of scenario No. 1 and scenario No. 2 could provide perspective on the possible impacts to different investment strategies. For example, in the charts below we can see summarized results for both Europe and US government, corporate, high yield bond sectors and the equity sector under both an increase in geopolitical tension and intensified geopolitical fragmentation.

It is not surprising that the equity market responds more acutely to the increased risk given bonds, which can serve as a safe-haven asset, would attract more investors in times of volatility. The government bond sector is least impacted by both scenarios as it is considered the most solid in vulnerable times.

Another aspect to note in the above charts and results is that the scenarios on geopolitical fragmentation have notably large impacts across all sectors. Those scenarios imply shocks with larger economic and financial impact, as there is potential or actual slowdown of trade or economic activities. Restricting the supply of goods or services leads to higher prices.

For example, when multiple countries applied wide-ranging trade, financial, and business sanctions against Russia in 2022 (mid-February to mid-March), the European equity market dropped by 10%, the volatility index and corporate spreads rose by 40%, and crude oil price rose 12%. Those are acute shocks to the financial market and the value of investments.

For each of the scenarios and portfolios we can go into more detail in the stress test results. We can further analyze the contribution to the portfolio return under a given scenario and slice it across the asset groups or factors that lead to it.

For example, if we take scenario No. 1 (geopolitical fragmentation intensifies) and the US Corporate Bond Index on the plot below, we find the contribution of the return is driven mainly by bonds from the Industrials sector. It’s not surprising given the index is predominantly invested in bonds in that sector.

For the Utilities and Financials sectors, however, there is discrepancy in the order of weight and contribution to returns under the scenario. That indicates the Utilities sector is more vulnerable to a shock in the scenario.

Another perspective to be gained in the analysis is factor contribution to the scenario return. Specifically, decomposing the return of -0.54% at the portfolio level to factor buckets of -0.134 from the US government bond curve and -0.404% from US corporate bond spreads. And that could be further sliced into sector spreads, with the largest contribution from Industrials sector corporate spread of -0.294, Financials of -0.112 and Utilities of -0.10, and even smaller from the sub-sectors such as Healthcare and Technology, for example.

Conclusion

Both scenarios we set up—geopolitical fragmentation intensifies and geopolitical tension increases—may serve as a base for you to analyze the impact to your investment strategies. You can build on them by using specific assumptions or accounts for a specific event and modifying the scenario returns—or also editing the predictive factors set in the scenarios.

There is a lot of flexibility to explore geopolitical aspects on your portfolios and the drivers behind the scenario returns, available as default Thematic Scenarios in the Portfolio Analysis Stress Testing report in the FactSet Workstation.

This blog post is for informational purposes only. The information contained in this blog post is not legal, tax, or investment advice. FactSet does not endorse or recommend any investments and assumes no liability for any consequence relating directly or indirectly to any action or inaction taken based on the information contained in this article.