ResearchFocus Geopolitics 100615

Geopolitics: the blind side
Wealth Management Research I July 2010
UBS research focus

Geopolitical events are hard to predict and often destabilizing
Investment decisions rarely incorporate geopolitical risks
Economic tensions raise risk of geopolitical conflict
Stress points: resources, nationalism, ideology and income gaps
Financial market impact varies widely depending on events
Preventive steps can limit losses but reactions also matter
AB
Contents
Editorial 3
Highlights 4
Introduction 5
Why geopolitics matters
Chapter 1 10
Investing under geopolitical risk
Case studies 16
Geopolitical hot spots
Natural resource needs: 17

• An object in motion: China’s slowdown and its implications
• Energy and nationalism: Russia, its neighbors and Europe
National strategic ambitions: 20

• The Middle East heats up: the gathering storm over Iran and Israel
• Asia’s nuclear brinksmanship: safer or more unstable?
Non-state ideological ambitions: 23

• Terrorism: the unknown unknowns
Income inequality: 24
• The future of the EMU: until stress do us part
• Raising barriers: the allure of trade protectionism
Chapter 2 28
Geopolitical risk in a portfolio context
Conclusion 34
The blind side
Bibliography 36
Publication details 38
This report has been prepared by UBS Financial Services Inc. (“UBS FS”) and UBS AG.
Please see important disclaimer at the end of the document.
Past performance is no indication of future performance. The market prices provided are closing prices on the respective
principal exchange. This applies to all performance charts and tables in the publication.
2 Geopolitics: the blind side

Dear reader,
Geopolitical risk is in a constant state of flux, lurking in the how financial markets and the economy respond to a wide
background with the potential to blindside investors. At spectrum of “real world” events that are not quantifiable,
times, geopolitical risk is on the rise, making the world a including the highly unpredictable realm of geopolitics. But
more unstable place. Other times, the risk fades from view. while assigning probabilities to potential geopolitical risk
scenarios may be difficult, in no way should these risks be
The end of the Cold War fundamentally altered the course dismissed.
of history as the twentieth century drew to a close. The
relaxation of geopolitical tension in the 1990s coincided In this UBS research focus, we seek to answer many of
with the spread of globalization, quantum leaps in technol- these questions, as well as: provide a useful framework for
ogy and privatization of state-owned industries, all of understanding how different geopolitical events are
which encouraged a further moderation of inflation and reflected in financial markets; survey the most potentially
growing economic prosperity. In addition, the global econ- eruptive sources of conflict; illustrate how investors can
omy accrued a “peace dividend” as the threat of mutually preemptively protect their portfolios from these risks; and
assured destruction subsided and defense spending shifted offer guidance on how to react to geopolitical events once
to more productive activities. they surface.
In recent years, however, economic activity and financial

market performance have grown increasingly turbulent, in
part due to imploding asset bubbles – first technology and
then housing. But renewed geopolitical upheaval – such as
the 9/11 terrorist attacks, the proliferation of nuclear
weapons capabilities in Asia and the threat of the Euro-
zone’s breakup – also left their mark.
The attempted car bombing in New York’s Times Square,

as well as the sinking of a South Korean warship in March,
remind us how quickly events can unfold to alter the
geopolitical landscape. Moreover, the economic and politi-
cal stresses that have surfaced in the aftermath of the
financial crisis suggest that geopolitical conflict could esca-
late further. Therefore, we think geopolitics will become
much more important in determining outcomes for the
economy and financial markets than in the recent past.
Geopolitical events shape the economic environment and

fundamental investment outlook. The type of geopolitical
event may determine how financial markets behave and
whether the reaction is more temporary or sustained, and
more localized or global.
As economists, analysts and strategists, we calculate fore-

casts using quantifiable variables that can be incorporated
into statistical models. However, we must also consider
Andreas Höfert Mike Ryan Kurt E. Reiman

Global Head Head Wealth Management Research – Americas Head Thematic Research – Americas
Wealth Management Research
UBS research focus July 2010 3

Highlights

Economic tensions raise the risk of geopolitical conflict 2007. However, the 9/11 terrorist attacks and the global
We think geopolitics will become much more important in credit crunch – two events that are defined by a “before”
determining economic and financial market outcomes than and an “after” – took nearly everyone by surprise.
in the recent past. Widespread economic dislocations, such
as higher unemployment, pervasive income inequality and Geopolitical events often appear unpredictable and uncer-
more government intervention in economic affairs, corrode tain before they take place. As a result, market participants
political stability. Tensions are already high between nations frequently treat the subject as an afterthought. However,
confronting natural resource scarcity, development of mili- we think this is a mistake. Geopolitics can heavily influence
tary and nuclear weapons capabilities, trade protectionism economic growth and asset returns and can blindside an
and fundamental clashes over ideology. While these trends investment portfolio.
may not necessarily be cause for alarm, they are certainly
worthy of greater attention. Therefore, we believe a Financial market impact varies widely depending on
deeper understanding of geopolitical risk and an assess- the event
ment of the most important potential hot spots will prove The defining geopolitical events of the past hundred years
beneficial to investors. – the two world wars, the Cuban Missile Crisis, the OPEC
oil embargo, the end of the Cold War and the 9/11 terror-
Stress points: resources, nationalism, ideology and ist attacks, to name a few – produced highly varied finan-
income gaps cial market outcomes. Some were long-lasting, some were
In our view, geopolitical tensions fall into four broad the- short-lived. Certain events had a localized impact, while
matic categories: natural resource needs; national strategic others were truly global. And some destroyed entire coun-
ambitions; non-state ideological ambitions; and income tries and disrupted economic activity, while others were
inequality. Each category contains different broad types of more benign.
geopolitical threats, which themselves lead to a variety of
financial market outcomes: Geopolitics must be understood as a type of risk that inter-
acts with other sources of risk in an investment portfolio. A
Natural resource supply shocks, such as an oil embargo, negative geopolitical event will tend to increase the risk
would likely create stagflation, whereas a clash over premium and alter the direction of asset prices. However,
access to resources could spark flight to safety flows. when a geopolitical event also depresses economic growth
and changes the course of inflation, then the effect on
National strategic ambitions, such as Iran’s acquisition of financial markets is likely to be more sustained. The direc-
a nuclear weapon or a standoff over Taiwan, would also tion of the impact will depend on the asset in question,
increase risk aversion. However, other strategic pursuits, and the magnitude will depend on the severity and resolu-
like a full-scale nuclear attack or sustained armed conflict tion of the incident.
could lead to extreme economic outcomes, such as
hyperinflation or depression. Preventive steps can limit losses but reactions also
matter
Ideological clashes usually surface in the form of sudden Diversification and ongoing risk assessment are important
terrorist attacks, which are usually associated with flight- precautionary measures to limit losses, but how one reacts
to-safety flows. But the outcome could be more devas- to the shock of a geopolitical event can be just as important,
tating if the attack arrives in the form of a nuclear device if not more so. When there is little transmission of a geopo-
or biological agent. litical shock to the broader economy, as is often the case with
smaller-scale terrorist attacks, the effect on financial markets
Income inequality could lead to trade wars and currency may be only temporary. As a result, the cost of hedging these
crises, which would likely spell deflation and depression. fleeting risks would likely outweigh the benefit.
Geopolitical events are hard to predict and often One option to consider when investing during prolonged
destabilizing periods of heightened geopolitical risk is to target assets
Investors experienced two of the worst financial market that would be expected to perform well both in a baseline
downturns in postwar history during the past decade scenario and when tensions boil over. Another is to seek
alone. There were some who saw problems on the hori- natural hedges. For example, commodities would stand to
zon, but few predicted the two systemic shocks that fully gain from conflict in the Middle East or a standoff over
undermined confidence. Some viewed technology shares resource access between China and India. In addition,
as expensive before the bubble burst in 2000 and many allocations to higher-quality government bonds, such
thought the housing market was due for a correction in as US Treasury securities, can offset declines when uncer-
tainties surge.

Introduction
Why geopolitics matters
Geopolitics reconsidered A world at a crossroads

With the world economy as globalized as it is today, Geopolitical risk refers to low-probability, high-impact
regional or domestic events transmit rapidly to the interna- events. They are the types of events that are proverbial
tional stage and can take many forms. People often think “bolts out of the blue” or that appear unpredictable and
geopolitics is primarily concerned with armed conflict highly uncertain before they take place. But while geopoli-
between nations. While this certainly plays an important tics may be difficult to include in statistical forecasting
role, the concept is far broader: tools, we have just demonstrated that it cannot be
completely ignored either. After a decade bookended by
A currency devaluation led to the 1994 Mexican peso an imploding tech bubble and the worst global recession
crisis. in postwar history, investors have become acutely aware
of how unanticipated events can blindside an investment
The imposition of tariff barriers in the 1930s is widely portfolio. Some saw dark clouds looming; few braced
considered to have contributed to the severity of the themselves.
Great Depression.
Geopolitical risk on the rise
The 2001 terror attacks in New York City quickly led to In our view, investors would be well advised to give more
two separate wars on the other side of the world, involv- attention to the effects of geopolitical risk on the economy
ing the armed forces of multiple nations. and financial markets. Many signs point to an increased
level of geopolitical risk in the world today:
Each of these geopolitical events had massive financial
and economic consequences. But too often, financial and The fragile state of the world economy
economic decisions are made independently of political
considerations. When attempting to predict future out- The increased role of government in economic affairs
comes, financial analysts and economists typically lump
“politics” in with other variables that are too uncertain and High unemployment rates and widespread income
therefore difficult to predict. In statistics, this is called the inequality
“error term.”
Decreased support for free trade measures and greater
In 1943, sociologist Werner Cahnman defined geopolitics use of protectionism
this way: “Historic forces operating within a geographic
framework are supposed to condition political action The heightened level of tension in key global hot spots
which, in turn, is to determine the course of economic
development.” Notice how geopolitics is ultimately about Steadily higher military spending
economics. In 2009, however, political scientists Ian Brem-
mer and Preston Keat defined geopolitics as “the study of Growing scarcity of certain natural resources
how geography, politics, strategy, and history combine to
generate the rise and fall of great powers and wars among Shifts in the global balance of power
states.” Although Bremmer and Keat do not specifically
mention economic factors, they consider the “rise and fall Fundamental clashes over ideology
of great powers” as principally an economic concept. In
other words, economics and geopolitics are inseparable.

Introduction
Fragile state of the world economy their efforts to fund important social programs. And now
Although the global economy is steadily recovering from that lifestyles are less often financed by credit, widespread
the recent “Great Recession,” the collateral damage income inequality is much more apparent, exposing the
remains acute and will take years, if not decades, to heal. reality that incomes have stagnated for the past three
Governments were quick to respond with fiscal stimulus decades except for the highest earners (see Fig. 3).
and monetary policy measures. However, a sustainable
growth path remains elusive for many developed countries Decreased support for free trade and greater use of
because of high household debt levels, depressed housing protectionism
values and a diminished appetite for consumer credit. Sources of stress are not just confined to the weak finan-
cial and employment conditions in developed countries;
Increased role of the state in economic affairs many of today’s problems transcend national boundaries.
Developed countries face the greatest hurdles in getting High unemployment has predictably stoked protectionist
their economies back on a sustainable path. Unsurprisingly, sentiment as politicians and special interest groups fight
they have also seen the largest increase in the role of gov- for their constituencies. Moreover, increased government
ernment in their economies (see Fig. 1). Meanwhile, more spending in the economy, a crowded regulatory reform
and more disillusioned people, having concluded that agenda, slow progress on global trade liberalization and
“free markets” were largely responsible for creating the the announcement of new tariff and non-tariff measures
systemic failures of the global financial system in the first all point to a rise in the use of protectionism. Against such
place, are demanding that their governments solve their a backdrop, the long-enduring march of globalization
financial and economic problems. In this tightly intercon- appears to be at a crossroads. The outcome – more conflict
nected world, the heightened role of the state in economic and heightened protectionism, on the one hand, or deeper
affairs suggests that geopolitics will become much more integration on the other – hinges more on political will
important in determining outcomes for the economy and than on economic considerations.
financial markets than in the recent past.
These protectionist tendencies serve as an important
High unemployment rates and widespread income reminder that economic integration is only as strong as the
inequality international and national political institutions that are
In addition to bailing out the financial industry and provid- there to support it. One needs to look no further than the
ing liquidity to financial markets, this new increased level Eurozone to see how an underdeveloped political frame-
of government intervention in the economy is aimed at work failed to prevent member states from getting into fis-
reducing unemployment, which has soared to the highest cal hot water, which is heightening speculation about the
levels in a generation in many countries, and at protecting future stability of the common currency and the potential
threatened key domestic industries (see Fig. 2). Youth for the whole experiment to unravel.
unemployment is rampant in Europe and North America.
Highly skilled workers in many industries, such as construc- Heightened level of tension in key global hot spots
tion, wholesale distribution and retail, face structural Strong political institutions are also necessary to advance
impediments to finding new employment as a result of common international security goals, such as confronting
permanent job losses. This comes at a time when rising terrorist threats and controlling the proliferation of nuclear
levels of public debt are constraining governments in weapons capabilities (not to mention ensuring they are
Fig. 1: Increased government role in the economy Fig. 2: A sharp upturn in unemployment
Public debt as a share of GDP, in % Unemployment rate for selected countries, in %
125 25
100 20
75 15
50 10
25 5
0 0
1950 1960 1970 1980 1990 2000 2010 1990 1994 1998 2002 2006 2010
G7 Advanced economies France Greece Germany Japan

Spain Switzerland UK US
Source: International Monetary Fund Source: Bloomberg

never used). But just as commitments are being made to Terror in Iraq and Afghanistan explains much of the spend-
further reduce stockpiles of nuclear weapons and to pre- ing surge in North America, whereas the growth in defense
vent disused nuclear materials from ending up in the hands spending in Asia is primarily the result of China’s aim to
of terrorists, security experts believe that many countries, expand its naval power. While the overall trend in military
including Iran, are steadily advancing – and may even be expenditures does not ensure armed conflict down the
accelerating – their acquisition of nuclear weapons capabil- road, it does raise the stakes.
ities (see Fig. 4 and Fig. 5). Nuclear proliferation stands to
disrupt the regional balance of power in areas where Growing scarcity of certain natural resources
nuclear capabilities have developed and also raises uncer- Efforts to control greenhouse gas emissions and improve
tainty about the global balance of power. With nuclear the efficiency of natural resource use have also been met
proliferation increasingly likely in the years ahead, the with frustration as political leaders fail to agree on a set
implications for international security are more uncertain of binding environmental principles. Natural resources are
than ever. again in great demand and increasingly scarce, leading to
higher input prices, a shift in alliances for industrial and
Steadily higher military spending energy commodities and strategic stockpiling of invento-
After declining for many years, military expenditures have ries. A marked increase in commodities prices would likely
risen steadily since the turn of the century and now exceed become an additional source of instability much like the
the level that prevailed at the end of the Cold War (see Fig. situation that occurred in 2007 and 2008, when agricul-
6). The bulk of the increase in defense spending has taken ture and energy prices led to massive protests (see Fig. 7).
place in North America and Asia. Financing for the War on Moreover, the simple fact that a country is an exporter
Fig. 3: Highest earners take a larger share of the pie Fig. 4: A steady destocking of nuclear weapons
Income share for the top 10% of earners in the US, in % Global nuclear weapons stockpiles, in thousands of warheads
55 75
50 60
45 45
40 30
35 15
30 0
1920 1935 1950 1965 1980 1995 2010 1945 1955 1965 1975 1985 1995 2005
Excluding capital gains Including capital gains US Former Soviet Union/ UK, France & China Total
Russia
Note: Income is defined as market income and excludes government transfers.
Source: Saez and Piketty (2009) Source: Norris and Kristensen (2009)
Fig. 5: Nuclear weapons states and programs
Country Date of first test Code name Comprehensive Test

Ban Treaty Status
Declared nuclear weapons states
US July 16, 1945 Trinity Signatory
Russia (former Soviet Union) August 29, 1945 First Lightning Ratifier
UK October 3, 1952 Hurricane Ratifier
France February 13, 1960 Gerboise Bleue Ratifier
China October 16, 1964 Lop Nor Signatory
India May 18, 1974 Smiling Buddha Non-signatory
Pakistan May 28, 1998 Chagai Hill Non-signatory
North Korea October 9, 2006 -- Non-signatory
Undeclared nuclear weapons states
Israel -- -- Signatory
States with suspected clandestine programs
Iran -- -- Signatory
Source: Carnegie Endowment for International Peace, Comprehensive Test Ban Treaty Organization Preparatory Commission

Introduction
of an economically important commodity significantly This relative shift of economic power underscores an evolu-
influences relations among states and complicates tion in the global geopolitical landscape from a world
important international security objectives, such as the largely dominated by the US to a multi-polar world where
difficulty in applying trade sanctions against Iran for its fail- the US is still the greatest power – but the gap between
ure to comply with international regulations regarding its the US and the rest is narrowing. As the relative balance of
nuclear program. power shifts between and among nations, geopolitical
activity will likely increase, with nations still adjusting to
Shifts in the global balance of power the new strategic equilibrium. There may come a point
Rapid rates of economic growth in emerging market coun- when nations “test” each other, trying to determine the
tries is often considered in purely economic terms, but limits of power. With the strategic boundaries between
there is also currently a very important geopolitical dynamic some great powers less defined than they once were,
taking shape. Notice how in the aftermath of the financial greater friction could emerge between current and emerg-
crisis, the G7 (an association of mostly developed nations) ing great powers.
has been almost completely supplanted by the G20 (an
association of emerging market and developed countries). Pointing fingers
This is hardly surprising. The financial crisis erupted in The world economy is far more interconnected than ever
developed countries where it left many structural problems before, which, in “normal” times, would be a sign of
in its wake, whereas emerging market countries came greater cohesion among countries and would tend to
away relatively unscathed. reduce the threat of geopolitical events. Unfortunately,
these are not normal times. Policymakers will need to focus
China is now the third largest economy in the world (calcu- on pain management and important domestic problems.
lated using market exchange rates) and will soon eclipse They will need to grapple with tough decisions about how
Japan for the number two spot. This means that the great- to reduce unemployment, control public debt growth, raise
est imbalances in international trade and finance – China’s domestic exporters’ international competitiveness, regulate
stockpiling of US dollar-denominated foreign exchange the financial sector and retain access to scarce natural
reserves and the persistently large US current account resources. But after increasing the public sector debt load
deficit – exist between the world’s largest and soon-to-be and running an exceptionally loose monetary policy, policy-
second-largest economies (see Fig. 8). It is for this reason makers are facing these challenges with ever fewer
that Larry Summers, former US Treasury Secretary, spoke in options. An increase in voter dissatisfaction could trigger
geopolitical terms when he dubbed this relationship the increased popular support for protectionist measures to
“balance of financial terror.” It explains why the US is cau- solve domestic economic concerns.
tious about branding China a “currency manipulator” and
why China is careful about how it phrases its views on the A risk too important to be ignored
US trade deficit and debt buildup. For either side to be cav- Because geopolitics is unpredictable and cannot be timed,
alier with this much at stake would be foolish. it is often treated as an afterthought when making invest-
Fig. 6: Sharp rise in post-Cold War military spending Fig. 7: Energy and metals prices have rebounded
World military expenditures, in trillions of USD Commodity price indices (January 2000 = 100)
1.3 600
1.2 500
400
1.1
300
1.0
200
0.9
100
0.8 0
1988 1992 1996 2000 2004 2008 2000 2002 2004 2006 2008 2010
Note: Data for 1991 are unavailable. Energy Metals Food

Source: Stockholm International Peace Research Institute Yearbook 2009, SIPRI Military Expenditure Database Source: International Monetary Fund

ment decisions, but it should not be ignored. According to

Bremmer and Keat, “A growing number of investors and
policymakers understand the importance of political risk.
Yet, they also know that they lack a comprehensive and
systemic set of tools for evaluating these risks.” While we
do not attempt to assign probabilities and timing to the
major hot spots throughout the world, we think these
events can be better understood and evaluated in order to
reduce the overall level of risk within an investment portfo-
lio. In Chapter 1, we review the geopolitical hot spots that
we think are the most potentially destabilizing to financial
markets.
We have developed a framework for incorporating geopo-

litical risk into the investment decision-making process. We
will take these matters up in Chapters 1 and 2. Chapter 1
explains how geopolitical risks can affect key economic
variables and asset classes, while Chapter 2 evaluates these
risks in a portfolio context. While this type of analysis does
not lend itself to specific investment recommendations,
there are numerous benefits, such as having a better
understanding of how geopolitics affects your investments,
and knowing how to react to various geopolitical events,
as well as how to better protect against them.
Fig. 8: Global imbalances continue

Current account balance for selected countries and regions, in % of world GDP
3
2
1
0
–1
–2
–3
1996 1998 2000 2002 2004 2006 2008 2010
US Oil exporters Germany and Japan

Other CA China and Rest of the world
deficit countries emerging Asia
Source: International Monetary Fund

Chapter 1
Investing under
geopolitical risk
Geopolitics drives economic growth and asset returns. But since probability, causality,
timing, magnitude and impact are difficult to assess, market participants rarely give
geopolitics the full attention it deserves. We think a deeper understanding will yield
benefits to investors.
Geopolitics matters to financial markets lowed the Great Depression. But this would be a mistake,
The idea that geopolitics influences financial market per- since it was the large mobilization of labor and resources
formance may seem intuitive to most investors. However, if toward supplying the war effort that benefited equities,
the idea is so obvious, then why is the topic given such lit- despite the high rates of inflation that emerged.
tle time and attention in financial circles? Moreover, when
geopolitical events are finally discussed in a financial mar- On the other hand, German, Japanese and, to a lesser
ket context, why are they almost always mentioned in extent, French equity markets were dealt a serious blow
passing as a blanket risk to equity market performance, during WWII given hyperinflation and destruction to the
without much reflection on some of the potential future countries’ infrastructure and productive capacity. The 1973
scenarios and implications for other asset classes? Organization of the Petroleum Exporting Countries (OPEC)
oil embargo and accompanying stagflation also reduced
The past century produced its share of monumental geopo- real equity returns to the same extent as during the two
litical events (see Fig. 1.1). Given the magnitude, the bigger world wars, and the impact was felt pretty evenly through-
surprise would have been if these events had had no impact out the world. And although the 9/11 terrorist attacks
on financial markets at all. Indeed, these events did pull were a localized event, they had a sustained global impact
world equity market indexes sharply lower (see Fig. 1.2). on equity markets (see Fig. 1.3). This is quite possibly
But each event has to be understood in its own context. related to the fact that the global economy was already in
the midst of a slowdown in response to the bursting of the
Bucking the broader global trend, US and UK equities gen- tech bubble when the attacks took place.
erated modest but positive real (inflation-adjusted) returns
during World War II (WWII), which may have conditioned Meanwhile, the Cuban Missile Crisis had a temporary
many Anglo-Saxon investors to conclude that this period impact on financial markets. Although the crisis brought
was just an extension of the economic recovery that fol- the world to the brink of what could have been nuclear
Fig. 1.1: Major geopolitical events of the past century Fig. 1.2: Different events, countries and outcomes
Real equity return over selected periods, in %, calendar year returns
Date Event
28 Jul 1914 to 11 Nov 1918 World War I 75
1 Sep 1939 to 2 Sep 1945 World War II 50
25 Jun 1950 to present Korean War (ceasefire signed 27 July 1953) 25
1959 to 30 Apr 1975 Vietnam War 0
29 Oct 1956 to 6 Nov 1956 Suez Crisis –25
14 Oct 1962 to 28 Oct 1962 Cuban Missile Crisis –50
19 Oct 1973 to 18 Mar 1974 OPEC oil embargo
–75
9 Nov 1989 Fall of the Berlin Wall
–100
11 Sep 2001 to present 9/11 terrorist attacks and War on Terrorism France Germany Japan UK US World World
ex-US
World War I (1914–18) World War II (1939–48)

Oil shock (1973–74)
Source: UBS WMR Source: Dimson, Marsh and Staunton (2008)

annihilation, the economy was never affected and political Flight to quality flows, as well as heightened liquidity
leaders found a peaceful solution. The crisis was reflected preferences and risk aversion, would tend to depress real
in equity markets predominantly through heightened risk interest rates
aversion and subsequent normalization when tensions
eased (see Fig. 1.4). Prospects for increased defense spending would likely
push inflation expectations higher
The nexus of geopolitics and finance
The key to assessing the investment implications of geopol- Increased uncertainty would be expected to increase the
itics lies in understanding how it affects the main drivers risk premium, at least among the affected countries
of investment returns. Fortunately, the same variables that
are relevant in any generic investment context are also Meanwhile, a sustained military offensive could lead to:
relevant for assessing the impact of geopolitical events
(see Fig. 1.5). A decline in trade, labor and investment flows, which
would reduce economic growth prospects in more than
Imagine an idealized situation when financial markets just the affected countries
capture all available information. In other words, stock
and bond prices reflect the expected real interest rate and Higher commodity prices (for example, energy), which
inflation rate, a risk premium to compensate for the would weigh on economic growth and increase inflation
uncertainty associated with risky investments and a liquid- expectations, potentially across the global economy
ity premium to compensate for the risk of being unable to
rapidly convert an investment into cash. In addition, stock A diversion of resources (including labor) to military use
prices reflect earnings growth prospects, while corporate would also likely drive up the cost of goods and wages
bond prices anticipate future credit trends and default
risks. Any short-term market price fluctuations from this A negative geopolitical event that increases the risk pre-
idealized starting point would result from changes to any mium will typically alter the direction of asset prices. If the
of these variables. event also depresses economic growth and boosts infla-
tion, such as with a sustained military offensive, then the
To the extent that political and geopolitical events affect effect on financial markets may be more long lasting (see
these factors, they have the potential to exert an influence
on financial market performance. The difficulty stems from
the fact that geopolitical events often affect several vari- Fig. 1.5: The main drivers of investment returns
ables at the same time, thereby making attribution and an Impact on financial markets assuming an increase in each variable
overall assessment less straightforward than meets the eye.
Variable Stocks Bonds
To illustrate, assume for a moment that a conflict erupts Real interest rates – –
between two neighboring states, diplomatic solutions are Inflation expectations – –
exhausted and military action looms. Such news, if unex- Risk premium – –
pected, is likely to affect the following market drivers: Growth expectations (economic, earnings) + neutral
Credit trends ? + (corporate bonds)
Liquidity premium – –
Source: UBS WMR
Fig. 1.3: 9/11 has sustained impact on global equities Fig. 1.4: Cuban Missile Crisis pulls equities lower
Equity price indexes (January 2000 = 100) Equity price indexes (January 1962 = 100)
120 110
100 100
80 90
60 80
40 70
20 60
2000 2001 2002 2003 2004 Jan 62 Apr 62 Jul 62 Oct 62 Jan 63 Apr 63 Jul 63 Oct 63 Jan 64
S&P 500 FTSE DAX Nikkei 225 S&P 500 DAX

Source: Bloomberg Source: Bloomberg

Chapter 1
the box on page 15 for a more detailed discussion). The Since a sustained geopolitical event often affects the rela-
direction of the impact will depend on the asset in ques- tionship between two or more sovereign nations, its
tion, and the degree of the impact will depend on the impact on economic activity will be visible in trade, capital
severity and the resolution of the incident. (portfolio and foreign direct investments) and labor flows.
This is the case even when the geopolitical event is con-
The economic consequences of geopolitics fined to a conflict within a nation, such as a civil war or
Since geopolitical events typically involve an abrupt change when a terrorist group attacks a sovereign state. In the for-
in behavior among conflicting parties, the impact on eco- mer, economic relationships with other nations would be
nomic activity will almost always be disruptive and rarely altered since capital and labor would be used to fight a
gradual. The disruption can be small or large, and it can war instead of to produce goods and services. In the latter,
affect political, business and personal ties to different the attacked nation might change its trade policy with
degrees, depending on the severity and type of event (see nations it considers “friendly” to the terrorist group that
Fig. 1.6). The shock generates a high degree of uncertainty, carried out the attack.
which is then reflected in a loss of business and consumer
confidence. These declines are typically large and signifi- Sustained geopolitical events will also have a visible effect
cant relative to the trends in place before the shock. on the fiscal balance of the affected countries. Depending
on the severity of the event, fiscal consequences include
The ensuing further erosion or recovery of confidence increased government spending for counterterrorism sur-
depends on the nature of the geopolitical event and its veillance and protection, as well as defense spending and
ultimate resolution. If the shock is more temporary, such as infrastructure reconstruction. The implication is that fiscal
a localized terrorist attack or a border conflict, then the deficits and debt-to-GDP ratios tend to rise in countries
economic consequences will likely be minimal and the affected by geopolitical conflicts. With most countries
financial market outcome will amount to flight to safety already experiencing a sharp deterioration in these metrics
flows. If allowed to persist, the large negative blow to con- in the aftermath of the financial crisis, a severe geopolitical
fidence can linger as sentiment feeds on itself. Sustained conflict would impair global fiscal balances even further
negative geopolitical events – such as global wars, resource (please see the April 2010 edition of the UBS research
supply shocks and trade protectionism – often produce focus “Public debt: the challenges ahead” for more infor-
shifts, or breaks, in existing trends and behavior, which can mation on public debt).
then lead to a slowing of economic activity and changes in
the inflation outlook.
Fig. 1.6: Transmission of geopolitical shocks to economics

High growth
Goldilocks Supercycle
Flight to safety
Terrorist attack
Temporary Access to nuclear weapons
Border / territory dispute
Conflict over resources
Present
Low growth
Trade protectionism Persistent

Resource supply shock
Currency crisis
Conflict over resources
Negative growth
Terrorist attack
Nuclear attack
Sustained global war
Deflation Stagflation
Negative inflation Low inflation High inflation
Source: UBS WMR

Bridging the divide its position as Europe’s natural gas supplier through an
We can now see that there are not only numerous types of embargo. As well, Iran could disrupt oil supplies in reac-
geopolitical events, but also a wide array of potential tion to economic sanctions aimed at curbing its nuclear
financial market outcomes. By identifying the geopolitical program or a preventive strike by Israel. Actions that
events and potential triggers, the economic and financial restrict the supply of natural resources will most likely
market consequences begin to take shape. Therefore, we constrain economic activity and raise inflation, at least in
built a framework in order to bridge the gap between the short term, which would be a positive scenario for
geopolitical events and financial markets. We categorized certain commodity subsectors. However, not all clashes
geopolitical stresses along four thematic lines and also over resources lead to stagflation. Importing countries
included examples of specific events and triggers. For each will do everything in their power to secure access to
of these events, we identify the likely consequences for natural resources. A military standoff would likely trigger
financial markets. While the framework is only as strong as heightened risk aversion and an increase in the risk
the level of understanding and nuanced assessment of premium.
each separate geopolitical conflict, we think it represents a
marked improvement in how to think about geopolitical National strategic ambitions. When countries build
risk in an investment context. Fig 1.7 illustrates our new strategic capabilities or attempt to exert influence
approach. over others, such as the pursuit of nuclear weapons in
Asia, the initial phase can lead to a flight to safety. Even-
Four thematic categories of geopolitical stress tually, however, these developments can lead to armed
In general, we think the four main geopolitical clusters conflict (see the box on page 15 for a more detailed dis-
include: natural resource scarcity, national strategic ambi- cussion). Geopolitical events that involve strategic ambi-
tions, non-state ideological ambitions and income inequality. tions tend to be negative for growth and fairly neutral
for inflation, assuming they do not escalate into a multi-
Natural resource needs. Endowment of critical natural country war or nuclear attack. The typical reaction in
resources confers a strong geopolitical advantage to these more muted scenarios, especially if the potential
exporting countries. As we explore in detail in the fallout is large but the event is short-lived, is to park
geopolitical case studies, Russia might seek to leverage money in safe haven assets, which currently include US
Fig. 1.7: The varied effects of geopolitical shocks on financial markets
Geopolitical events Impact on assets

Sources of stress Geopolitical events Specific shock or trigger Asset consequences
Natural resource needs • Resource supply shock • Russian energy embargo Stagflation
• Oil supply disruption • Government bond prices down
• Stocks mixed
• Gold up
• Commodities mixed
• Conflict over resources • Standoff over resource access between China and India Flight to safety
• Coup in Saudi Arabia • Disputed water access rights • Government bond prices up
• Stocks down
• Iran / North Korea develop nuclear capabilities
• Gold up
National strategic • Access to nuclear weapons
ambitions • Taiwan / China escalation
• Reserve currency up
• Border / territory dispute
• Commodities mixed
Non-state ideological • Terrorist attack • Car bomb in Times Square
ambitions
• Terrorist attack • Nuclear or biological attack Hyperinflation
• Paper assets down
• Sustained global war* • Broad escalation of military conflict • Hard assets up
• Nuclear attack • Use of nuclear first-strike capabilities
OR
Depression / deflation
Income inequality • Trade protectionism • US / China trade war
• Government bond prices mixed
• Currency crisis • Euro collapse
• Stocks down
• US dollar collapse
• Gold mixed
• Commodities down
*Historical experience shows that hyperinflation results after sustained global wars.
Source: UBS WMR

Chapter 1
Treasuries and gold. However, other strategic pursuits, Europe after the devastation wrought during the twenti-
such as a full-scale nuclear attack or sustained armed eth century, hence the importance attached to maintain-
conflict, could lead to extreme economic outcomes, such ing the currency union.
as hyperinflation or deflation.
Taking stock
Non-state ideological ambitions. Fundamentalist This categorization of geopolitical conflicts is meant as a
views and ideological ambitions become geopolitical framework for evaluating geopolitical risk and its implica-
events when they erupt in the form of terrorist attacks. tions for economic activity and financial markets. Clearly,
According to a recent study (Carrera and Mussio), terror- the location, duration, magnitude, impact and catalyst of
ist attacks usually only have a fleeting impact on equity each geopolitical event will have a material effect on how
returns. The authors calculated the deviation from trend geopolitical risk manifests itself in various asset markets,
of daily equity returns for six countries in order to gauge hence the reason we provide detailed case studies of
the strength of the impact of terrorist attacks on equi- potential geopolitical hot spots. In Chapter 2, we will illus-
ties. They conclude that only a small share of the 1,312 trate how investors can preemptively protect their portfo-
recorded attacks from 1 January 2001 to 31 December lios from the negative consequences of geopolitical risk
2006 had a statistically significant negative effect on and, most important, provide advice on how to react to
stock prices on that day, and this usually faded soon these events once they surface.
thereafter (see Fig. 1.8). Unsurprisingly, the magnitude of
the effect was substantial for statistically significant
events, even after 11 days (see Fig. 1.9). Of all the terror-
ist incidents, the authors concluded that only the 9/11
attacks had a structural impact on equity market funda-
mentals. If future terrorist incidents undermine vital infra-
structure, such as a nuclear or biological attack, they will
likely have a persistent and damaging effect on equities
(see the box on page 33 for a more detailed discussion).
Income inequality. Protectionism is a greater risk when

labor markets are weak, as is the case now. Trade wars
and currency crises are usually the by-products of income
inequality among countries and the consequences are
usually deflationary, as reduced trade flows would likely
depress overall economic activity. They also carry the
potential for a wider escalation of conflict. At its most
basic level, the present crisis within the EMU stems from
income inequality and differences in competitiveness
among member states. Recall that the EMU developed
as an effort to reduce the potential for war within
Fig. 1.8: Small share of statistically significant attacks Fig. 1.9: Range of negative impact can be quite large
Share of terrorist attacks with statistical significance, in % Range of significant negative equity returns
40
1–day 6–day 11–day
Min Max Min Max Min Max
30
Colombia –1.0 –12.4 –3.0 –24.8 –6.0 –14.2
India –1.4 –6.0 –2.6 –5.0 –2.4 –5.8
20 Spain –1.5 –4.1 –6.4 –8.4 –8.3 –9.2
Thailand –1.9 –16.8 –5.2 –11.1 –3.8 –16.1
10 UK –1.6 –1.9 –1.7 –1.7 –3.8 –3.8
US –1.3 –3.0 –4.0 –5.1 na na
0
1-day 6-day 11-day
Colombia India Spain Thailand UK US
Note: Share of terrorist attacks that led to statistically significant negative equity returns on the day of the attack Note: Minimum and maximum of statistically significant negative equity returns on the day of the attack and after
and after 6 and 11 days. 6 and 11 days.
Source: Carrera and Mussio (2009) Source: Carrera and Mussio (2009)

War: the most devastating geopolitical risk

Each of the geopolitical hot spots that we outline in the other than trade activity influence the decision to go to
case studies has the potential to result in armed confronta- war and can even outweigh the importance of trade links
tion. When thinking about negative geopolitical events, between countries.
war has the most devastating economic and social impact.
It thus represents a worst-case scenario for how geopoliti- …and its economic consequences
cal events impact trade, capital and labor flows, as well as These same authors developed a model to estimate the
the overall level of economic activity. impact of war on the level of trade among country pairs.
To control for other factors that affect bilateral trade, they
The likelihood of war… include variables such as a country’s share of global GDP,
According to the “liberal peace” view, trade interdepend- per-capita GDP, shared land borders, whether the countries
ence deters conflict and promotes peace by generating share a common language, distance between the capital
economic benefits and raising the cost of conflict. The cities and others. Their model points to a strong negative
opposing “realist” view states that trade may create con- impact of war on trade (see Fig. 1.11). For 11,535 country
flict by intensifying competition and increasing depend- pairs from 1870 to 1997, war reduces bilateral trade
ence on strategic goods. A recent paper (Glick and Taylor) among warring states by a whopping 85% in the year
provides empirical evidence for the liberal peace view. The when war breaks out. Furthermore, the impact on bilateral
authors estimate the likelihood of war between nation trade lingers even after the war is over and usually takes
pairs based on: 10 years from the start of the war to fully recover. Five
years after the cessation of war, bilateral trade is still 43%
The level of their bilateral trade below its pre-war level.
Whether they share land borders Even the trade relationships of neutral countries are
affected. The model estimates that bilateral trade between
Whether they are members of the same alliance a neutral country and a country that is at war falls by 12%
in the year a war begins. Only after eight years is trade
Whether one or more is a major power restored to pre-war levels. Thus, war has a large and per-
sistent effect on the bilateral trade of belligerent and neu-
The number of years of peace since the last conflict tral countries. The loss in trade directly affects GDP growth
and indirectly alters capital flows and exchange rates. The
The results for 9,942 country pairs from 1870 to 1997 magnitude of the estimated impact of wars on economic
show that bilateral trade lowers the probability of war by activity suggests that the consequences for asset markets
about 50%. This is good news since globalization has led and financial portfolios are great.
to a higher degree of trade interconnectedness over the
past several decades (see Fig. 1.10). Of course, factors
Fig. 1.10: Steadily higher share of trade in global GDP Fig. 1.11: Impact of war on trade
Global exports as a share of GDP, in % Contemporaneous and lagged impact of war on level of trade, in %
30 25
24 0
–25
18
–50
12
–75
6
–100
0 1 2 3 4 5 6 7 8 9 10
0
1970 1980 1990 2000 2010 Trade between belligerent Trade between belligerent and neutrals
Note: The impact is calculated with a regression that controls for other drivers of trade. It measures the drop in
the pre-war level of trade in the year of the war outbreak and subsequent years.
Source: Thomson Financial Source: Glick and Taylor (2005)

Case studies
Case studies
Geopolitical hot spots
Geopolitical hot spots can quickly deteriorate from a system of managed tension into a
full-blown crisis. Although hard to quantify, an understanding of the most significant
geopolitical issues and potential future scenarios is a key input into sound financial risk
management.
Global tectonic shifts Common geopolitical themes

As we discussed in the Introduction, geopolitical risk may We conclude that the critical geopolitical hot spots
be difficult to quantify and assess in terms of probability, throughout the world can be broadly classified according
but this does not mean it should be ignored altogether. to the four sources of stress we outlined in Chapter 1:
Many of the steps leading to geopolitical unrest can be natural resource needs (China, Russia); national strategic
seen in advance; however, sometimes, geopolitical shocks ambitions (Iran, Asian nuclear); non-state ideological ambi-
appear out of nowhere. Even if the timing and magnitude tions (terrorism) and income inequality (EMU breakup,
of the fallout are uncertain, a thoughtful consideration of trade protectionism). While we would agree with many
the risks can provide important information to investors. observers who believe geopolitical stress is rooted in reli-
We have identified several geopolitical hot spots that have gious, cultural and ethnic tensions, we think these are
the potential to impact financial markets in the intermedi- either reinforced by or directed through each of these four
ate to long term. In this section, we present some back- aforementioned main channels. There is definitely some
ground information for each of these events and the steps overlap among the four categories; for example, Iran’s
that could lead to an escalation of conflict. In Chapter 1 nuclear pursuits are clearly strategic but are also shaped by
and Chapter 2, we consider these events in more general its role as a supplier of important energy commodities and
terms and show how they could potentially impact finan- how it sees itself relative to richer developed countries.
cial markets and investment portfolios. Having said this, the categories help to give some order to
what is otherwise a mostly chaotic subject.
Natural resource needs: Non-state ideological ambitions:

An object in motion: China’s slowdown and its Terrorism: the unknown unknowns
implications
Energy and nationalism: Russia, its neighbors and
Europe
National strategic ambitions: Income inequality:

The Middle East heats up: the gathering storm over The future of the EMU: until stress do us part
Iran and Israel Raising barriers: the allure of trade
Asia’s nuclear brinksmanship: safer or more protectionism
unstable?

Case studies
Natural resource needs
An object in motion: China’s slowdown nomic interests, including the safe transport of natural
resources and traded goods (see Fig. CS2). The short-term
and its implications risk of China’s naval buildup is that it raises the odds of an
accidental skirmish with the US; the longer-term conse-
The consequences of inflexibility quences relate to how it could shift the balance of military
One might expect a report about geopolitical risks to fea- power in the area off China’s immediate coastline. As
ture a discussion of potential friction points between China China becomes more influential in the region, the status of
as the emerging economic (and likely military) superpower Taiwan and long-running but largely dormant territorial
and the rest of the world. And, indeed, China’s expansion disputes with Japan and India become relevant sources of
does create these types of risks. However, given the widely potential conflict. Given US security guarantees for both
held view that China’s high growth rates will continue Taiwan and Japan, an escalation of tensions in these areas
uninterrupted for years, we also believe that investors could degenerate into a wider confrontation between
should not ignore risks associated with an unexpected China and the US. Similarly, the stakes could be high if
slowdown in this strong economic growth. We view China’s territorial dispute with India over the disputed terri-
China’s natural resource needs, domestic demographic pro- tory of Arunachal Pradesh heats up.
file, national strategic interests and central economic plan-
ning as important geopolitical and economic risks. Growing income, age and gender gaps
China faces several societal imbalances that could create
Resource hunger and neighborhood tensions internal tensions and instability. An expanding income gap
China is now the world’s second-largest consumer of crude between China's rural and urban dwellers could be fertile
oil, over half of which is obtained through imports, and the ground for internal discord. Also, similar to societies in the
leading consumer of copper, aluminum and zinc (see Fig. industrialized countries, China's population is steadily
CS1). According to journalist Robert Kaplan in the aging. In fact, it will age more quickly than that of both the
May/June 2010 edition of Foreign Affairs, “China’s actions US and Europe from now through 2050, with its working-
abroad are propelled by its need to secure energy, metals age population probably peaking in about five years (see
and strategic minerals in order to support the rising living Fig. CS3). China’s unbalanced gender structure could also
standards of its immense population, which amounts to create internal discontent. Partly as a result of its one-child
one-fifth of the world’s total.” Throughout human history, policy, expanding access to better prenatal diagnostics and
competition for scarce natural resources has often been a other cultural factors, the Chinese male-to-female ratio for
flashpoint among and within societies. For any large eco- children aged 0–4 years is now at 1.23. In other words,
nomic and military power, the use of force becomes a more there are 23% more young boys than girls (see Fig. CS4).
likely option when resource prices are high.
While not necessarily directly impacting geopolitical risks,
Today, world trade routes are secured primarily by the US these dramatic demographic shifts, in conjunction with a
Navy. However, China is also developing a naval force in relatively inflexible political system, do have the potential to
order to support and protect its own growing global eco- create social instability, with consequences for China's eco-
Fig. CS1: A voracious appetite for resources Fig. CS2: Chinese military spending growing rapidly
China's share of global commodity demand, in % Estimated military spending, in billions of USD
50 1000
40 800
30 600
20
400
10
200
0
0
Iron ore
Coal
Cotton
Copper
Aluminium
Soybeans
Corn
Oil
2010 2015
China US
Source: Bloomberg, Thomson Financial Source: US Department of Defense, US Office of Management and Budget

Case studies
Case studies
Natural resource needs
nomic growth and political institutions. We do not believe While the financial crisis seems to have shown that “free
China’s restrictions on freedom of expression create geopo- market capitalism” certainly has its limitations, central
litical risks per se. But any potential social disorder or politi- planning could result in a misallocation of resources that
cal instability would likely create far greater economic may lead to frictions with trading partners and ultimately
shockwaves than in the recent past. hobble the Chinese economy.
Consequences of the state's firm grip on the economy

Keep in mind that much of China’s economy is still con- Energy and nationalism: Russia, its
trolled by the state:
neighbors and Europe
The country’s exchange rate regime represents one
potential source of geopolitical friction. As we note in Resource ownership lends power
the section on protectionism, nations that feel threat- Russia’s growing strength as an oil and natural gas exporter
ened or unfairly treated by China’s currency policy may has reinforced its claim to power in the Eurasian region
implement trade-related retaliatory measures. However, (see Fig. CS5). Rather than integrating into the “Western”
Chinese authorities are encouraging companies to lift bloc as a strategic partner post the Iron
workers’ wages in order to boost domestic consumption Curtain’s fall, Russia has in several instances taken a more
and reduce export dependence. In our view, this is an confrontational stance. The oil price spike following the
effective way of addressing the currency issue, and we war in Georgia and repeated disruptions of Western
also expect a gradual nominal appreciation of the Chi- Europe’s gas supply after Russia’s disagreements with
nese yuan versus the US dollar, which further reduces pipeline transit states exemplify that access to scarce
the risk of protectionism. resources remains the greatest leverage that Russia can
exert over its neighbors and internationally.
Subsidized electricity prices risk sending the wrong price
signals to consumers and producers, creating the poten- Moscow’s firm grip on the energy sector
tial for enormous resource inefficiencies. The state’s grip on the Russian energy sector has been
expanded in recent years, for instance, by partially revers-
China’s subsidized bank lending risks redirecting financial ing some of the controversial privatizations of the 1990s
and natural resources into unproductive assets and creat- and limiting foreign oil firms’ ownership in strategic oil and
ing excess capacity within certain favored industry sec- gas projects. The natural gas sector is dominated by major-
tors that might then require their own price supports ity state-owned Gazprom, which owns the pipeline infra-
and subsidies. structure and so far holds a legal monopoly on natural gas
exports.
Fig. CS3: China to age faster than the US and Europe Fig. CS4: China’s surplus of boys
Share of population age 65 years and older, in % Number of male births per female birth
30 1.25
24 1.20
18 1.15
12 1.10
6 1.05
0 1.00
1950 1970 1990 2010 2030 2050 1995–2000 2005–10 2015–20 2025–30 2030–40 2045–50
China Europe US China Europe US
Source: United Nations Population Division Source: United Nations Population Division

Resources + Russian nationalism = Russian resource difficult economic environment, populist pressures could
nationalism? be on the rise. After Russia’s presidential elections in 2012,
Since the Soviet Union’s breakup, Russia has sought to Russian resource nationalism could experience a resur-
maintain strong links across Central Asia and Eastern gence if a candidate with an interest in more state domi-
Europe to reestablish itself as a major power and to unify nance in the energy sector were to take office.
its diverse regions as one nation. Taking a tougher stance
in its energy policy against outside powers could be one A disruption of energy supplies
factor in this contest; fierce competition with the EU and Russia supplies 33% of Western Europe’s oil imports and
the US for political influence in the region could be 40% of its gas imports, according to Europe’s Energy Por-
another. The victory of Russia-leaning Viktor Yanukovych in tal. Such a high level of dependence makes a disruption of
Ukraine’s February 2010 election was widely perceived as a supply channels particularly harmful to European economic
success. Sizzling conflicts in the Caucasus, through which growth. Any cutoff of oil and natural gas supplies or insta-
a number of important pipelines run, have caused instabil- bility due to incendiary conflicts in the Caucasus region
ity, and the March 2010 bombings in Moscow might would cause energy prices to rise and have an adverse
make future Russian military intervention in the region effect on global economic growth (see Fig. CS6). Accord-
more likely. ing to the International Energy Agency, a sustained USD 10
per barrel increase in the price of oil could lower global
Relations between Russia and the US have improved over GDP growth by 0.5 percentage points in the subsequent
the last few years; existing conflicts of interest seem to be year. Reduced private sector influence in Russia’s energy
deferred for the time being. For instance, the accession of market could also reduce investment in further exploration
Georgia and Ukraine to the North Atlantic Treaty Organiza- and returns on investments, which would trigger even
tion (NATO) has been put on hold. NATO’s possible expan- more supply pressures and higher energy prices.
sion in Eastern Europe had been mentioned in Russia’s
National Security Strategy of 2009 as a threat. Also, US
plans to station a missile defense system in Eastern Europe,
which Russia had perceived as a blatant offense, have
been abandoned for the time being. These latent conflicts
could cause irritations in the relationship to resurface if the
Western allies’ position changes.
Russia will also reap the benefits of higher energy prices,

even though the rest of the economy is suffering from a
severe recession and unemployment is rising. In this
Fig. CS5: Proven energy reserves Fig. CS6: A barometer of resource nationalism?
Crude oil, in billion barrels Natural gas, in trillion cubic feet Crude oil prices, in USD per barrel Natural gas prices, in USD per million BTUs
300 1,800 160 16

250 1,500
200 1,200 120 12
150 900
100 600 80 8
50 300
0 40 4
0
Saudi Arabia
Canada
Iran
Iraq
Kuwait
UAE
Russia
Venezuela
Libya
Nigeria
China
Qatar
Brazil
Kazakhstan
US
0 0
2000 2002 2004 2006 2008 2010 2012
Proven crude oil reserves (billion barrels, lhs) Crude oil (lhs) Natural gas (rhs)
Proven natural gas reserves (trillion cubic feet, rhs)
Source: Energy Information Administration Source: Bloomberg

Case studies
Case studies
National strategic ambitions
The Middle East heats up: the gathering and global war, driving a nuclear arms race among the
Gulf States and undermining the Nuclear Nonproliferation
storm over Iran and Israel Treaty (NPT). This is a situation the US and its allies would
like to prevent with sanctions – though military options
Heightened level of concern have not been taken off the table.
The US desire to curb Iran’s nuclear ambitions is nothing
new, and during his first few months in office, President Complications around successful sanctions
Obama pursued diplomacy over economic sanctions and During trips to the Middle East, US Defense Secretary
military force. Despite US outreach, Iran seems more closed Robert Gates noted that sanctions have only worked,
to nuclear negotiations since the widely debated June “because there was very broad international support and
2009 presidential election of Mahmoud Ahmadinejad. The there were very few cheaters.” Success of sanctions on
violent crackdown on the protests that erupted after the refined petroleum would depend on Russia, which sells
election have the US concerned with the regime’s human military goods to Iran, as well as China, which imports
rights violations, support for terrorism and threats to 11% of its oil from Iran. Even with international support,
national and global security, not to mention their nuclear sanctions could backfire and increase support for the
aspirations. Iran denies it is developing nuclear weapons; regime if the negative effects felt by the Iranian population
however, its rejection of the UN Security Council’s offer to are used to promote anti-American sentiment. This leaves
enrich uranium abroad – as well as the latest International the US in the unenviable position of supporting the oppo-
Atomic Energy Agency report of violations surrounding sition while aiming sanctions at the Revolutionary Guards
uranium enrichment, nuclear payloads and new enrich- and the Ahmadinejad regime, despite sending signals to
ment plants – has left the international community increas- Iran that it is no longer interested in diplomacy. US failure
ingly concerned about Iran’s intentions. to diffuse the situation, either through diplomacy or sanc-
tions, could prompt Israel to launch a preventive strike
Living with a nuclear Iran against Iran in an effort to protect what it considers an
Suzanne Maloney of the Brookings Institute believes the “existential” threat to its existence.
political crisis in Iran is weakening the probability of suc-
cessful engagement with the West: “the reality is that the Preventive strike: buying time worth the costs?
violence and continuing turmoil has made it almost impos- The Israeli government has signaled a willingness and an
sible to envision a successful negotiation with Tehran in ability to launch aerial, non-nuclear operations against Iran
anywhere near the timeframe necessary to avert Iran’s if necessary. There is precedent for such action. Israel
nuclear ambitions.” As the international community con- mounted successful preventive strikes against Syria in the
tinuously debates the best course of action, Iran may cur- 1980s and Iraq in the 1990s amid fears that each was on
rently, and certainly in the next five years, have nuclear the brink of acquiring nuclear weapons capabilities. Suc-
weapons capabilities. The US would have to respond to a cessful preemptive action would once again depend on
nuclear Iran with clear guidelines surrounding unaccept- intelligence of nuclear facilities, successful air attacks and
able behavior and be prepared to use military force if follow-up raids to destroy remaining facilities. But this
Tehran does not abide. James Lindsay and Ray Takeyh of could prove more challenging this time around given the
the Council on Foreign Relations have laid out conditions decentralized, hardened and dispersed facilities in Iran. An
Tehran must adhere to for successful containment to be attack would likely slow, but not end, Iran’s nuclear pro-
possible: “no initiation of conventional warfare against gram and retaliation would be inevitable. Israel could face
other countries; no use or transfer of nuclear weapons, missile counterattacks and terrorism from surrogate groups
materials, or technologies; and no stepped-up support for including Hezbollah and Hamas, which are supplied with
terrorist or subversive activities.” Compliance with the list’s rockets by Iran. Other states within the region might jump
requirements is certainly achievable, but the question into the conflict as a way of showing solidarity with their
remains whether Iran would take the US threat seriously Arab cousins against the Israelis. The US may also be
after once insisting it would never allow a nuclear Iran and drawn into the conflict as American interests in Iraq and
then being forced to accept it. Afghanistan could be compromised. Iran might target
Arab oil facilities in the Persian Gulf or disrupt oil ship-
While containment of a nuclear Iran may be possible, it is ments through the Strait of Hormuz, which ships 20% of
far more likely that its acquisition of nuclear capabilities will the world’s daily oil consumption. With Iran as the fourth-
create further instability in the Middle East. The compli- largest oil exporter in the world and second within the
cated and often conflicting outcomes of diplomacy, multi- Organization of the Petroleum Exporting Countries (OPEC),
lateral sanctions and military action are unknown. But it is such a disruption in oil supplies could push prices to never-
quite likely that a nuclear Iran could emerge as a dominant before-seen highs (see Fig. CS7 and Fig. CS8).
power in the Middle East, raising fears of nuclear strikes

Asia’s nuclear brinksmanship: safer or weapons. For example, the Kargil War of 1999 was precipi-
tated by Pakistani forces crossing India’s border in Kashmir.
more unstable? The rationale behind supporting extremist groups for Pak-
istan and its willingness to escalate conflict with India is to
Reaching all corners of Asia force international pressure on India to come to the bar-
Since their invention and use to end WWII, the threat of gaining table and resolve the dispute over Kashmir.
nuclear weapons to humanity has been persistent, even if
the threat level has fluctuated (see Fig. CS9). Since the If another deadly terrorist attack were to occur within
collapse of the Soviet Union, the most likely nations to be India, this could be the tipping point for a nuclear conflict
engulfed in nuclear war have shifted to Asia (see Fig. on the subcontinent. Indian officials believe that some of
CS10). South Asia and the subcontinent is a region marred the most severe terrorist attacks that have occurred within
by a history of violence and conflict since WWII, and the its borders were planned in accordance with Pakistan’s
two nations with the greatest history of conflict, India and Inter-Services Intelligence Directorate (ISI) – including the
Pakistan, both have a nuclear arsenal. The instability within Mumbai attacks in 2008 that took 170 lives. If a nuclear
Afghanistan has spread to Pakistan, where remnants of the war were to break out, the loss of life – both initially with
Taliban, the radical Islamic group, and other militant insur- the explosion and later on from radiation – would be cata-
gents are mounting fresh attacks. However, the bigger risk strophic, given the region’s high population density. India is
of nuclear war may lie to the north. Since 2006, Commu- on the record saying that it would only resort to using
nist-led North Korea has claimed it possesses nuclear “nukes” if Pakistan did first. However, previous Pakistani
weapons, although other nations suspect it is in the final regimes have said they would use nukes first if necessary.
stages of development. Either scenario is disconcerting
for the region, given North Korea’s history of unpredictable While Indian and Pakistani relations have remained tense,
behavior. the spreading of the Taliban insurgency into Pakistan is
worrisome given Pakistan’s possession of nuclear weapons.
On the subcontinent The Taliban came to control Afghanistan in 1996 with the
Since the bloody partitioning of British India in 1947, ten- help of the ISI. The Taliban was soundly defeated in 2001
sions between India and Pakistan have persisted, including during the US-led Operation Enduring Freedom. Remnants
three wars and numerous armed skirmishes. While the of the Taliban pushed across the border and reconstituted
genesis for the regional tension remains complex, the pri- themselves within the Federally Administered Tribal Areas
mary source – and also the likely trigger for another war – in western Pakistan. Pakistan is now waging an internal
rests with the continuing territorial dispute over Kashmir. war against the Pakistani Taliban. The outright theft of
The region’s stability was again in doubt in 1998 when nuclear weapons does not seem likely. Pakistan’s nuclear
Pakistan officially joined India in the possession of nuclear paraphernalia is spread out among various Pakistani mili-
weapons. Pakistan has a history of supporting the extrem- tary bases, and the complexity of constructing a nuclear
ist and separatist movements in Kashmir, which acceler- weapon reduces the risk that insurgents could successfully
ated in the years following Pakistan’s acquisition of nuclear launch and detonate a nuclear device. However, if the
Fig. CS7: Iran is the fourth-largest oil exporter Fig. CS8: Oil price doubled during Kuwait invasion
Leading oil net exporters, in millions of barrels per day, 2008 Real imported crude oil prices, in USD per barrel
10 60
8 48
6
36
4
24
2
12
0
Saudi Arabia
Russia
UAE
Iran
Kuwait
Norway
Angola
Algeria
Nigeria
Venezuela
Iraq
Libya
Canada
Qatar
Kazakhstan
0
1988 1989 1990 1991 1992 1993
Source: Energy Information Administration Source: Energy Information Administration

Case studies
Case studies
National strategic ambitions
Taliban gains ground and even potentially overthrows the

government, this would destabilize global security given
the potential for nuclear weapons to be sold to terrorist
organizations.
North by northeast
While the situation in South Asia remains delicate, some
experts would argue the larger problem within Asia lies in
North Korea. The sinking of a South Korean naval vessel in
March serves as a sobering reminder of the potential for
tensions to spark without notice. North Korea has a history
of provocation against the US, South Korea and Japan.
Some of the provocations included: attempted assassina-
tion of South Korean presidents; attacks on South Korean
warships; and terrorism and kidnapping.
While reports vary, it is believed that North Korea is at least

close to the final stages of developing nuclear weapons, if
not already in possession of them. It is unclear whether
North Korea seeks to secure nuclear capabilities in order to
obtain economic and strategic advantages if it disarms, or
whether talks are just a distraction from North Korea’s aim
of becoming a nuclear power. North Korea’s recent history
of erratic behavior under Kim Jong-il is worrisome and
makes determining a trigger for nuclear war all the more
problematic. Given Kim Jong-il’s poor health, succession
talks are important to understand in which direction North
Korean foreign policy will embark. It is likely one of Kim
Jong-il’s sons would take over and speculation is he would
maintain the same belligerent foreign policy.
Fig. CS9: The “Doomsday Clock” Fig. CS10: Nuclear weapons inventory in Asia
Minutes to “midnight” Range of estimated nuclear warheads, April 2010
20 300
16 240
12
180
8
120
4
60
0
1947 1960 1973 1986 1999 2012
0
China Pakistan India North Korea
Note: The Doomsday Clock conveys how close humanity is to catastrophic destruction – the figurative midnight –
and monitors the means humankind could use to obliterate itself. First and foremost, these include nuclear
weapons, but they also encompass climate-changing technologies and new developments in the life sciences that Note: Despite two well-publicized nuclear tests in 2006 and 2009, there is no publicly available evidence that
could inflict irrevocable harm. North Korea has nuclear warheads in operation.
Source: Bulletin of the Atomic Sciences Source: Federation of American Scientists

Case studies
Non-state ideological ambitions
Terrorism: the unknown unknowns does it carry over to economic activity. Therefore, terrorist
attacks on vital infrastructure are now the relevant
The real blind side unknown unknowns. Government surveillance efforts and
In 2002, former US Defense Secretary Donald Rumsfeld strategic considerations now focus on dismantling uncon-
described instability in the war in Afghanistan as such: ventional methods of disrupting the economy and society,
“There are known knowns. These are things we know that such as biological agents and nuclear devices. These have
we know. There are known unknowns. That is to say, there the potential to inflict mass casualties and wipe out essen-
are things that we now know we don’t know. But there tial services and economic activity, especially if they infil-
are also unknown unknowns. These are things we do not trate large metropolitan areas.
know we don’t know.” Despite the ridicule he endured at
the time, his categorization of the different combat risks The thwarted terrorist attack in New York’s Times Square in
gave a great deal of insight into the complexities of strate- May, as well as Richard Reid’s failed attempt to detonate an
gic decisions at a time of war. explosive device on a flight from Paris to Miami in 2001,
are highly fortunate outcomes. But while these plots were
Terrorism falls somewhere in between the known capable of doing enormous damage in terms of loss of life
unknowns and the unknown unknowns. For people in and property, the magnitude would pale in comparison to
many countries, such as Israel and Northern Ireland, terror- the extreme forms of terrorism now being seriously con-
ism has regrettably become a reality of daily existence – a templated by counterterrorism experts. Although the
known unknown. Prior to the 2001 terrorist attacks, flying potential for a terrorist attack cannot be measured with
airplanes as missiles into buildings was unthinkable to most any precision, we think the more important consideration
people – an unknown unknown – even for those in the is to evaluate the severity of any terrorist attack and
intelligence community. The 9/11 attacks also represented whether it impairs vital infrastructure.
a structural break for financial markets, as we showed in
Chapter 1, and they ushered in a new era of government
spending to finance counterterrorism efforts. As a result,
the threat of a terrorist attack on vital infrastructure is now
a known unknown for experts.
Terrorist attacks, by their very nature, exploit the element

of surprise and therefore cannot be predicted. With luck,
they can be spotted in advance and defused, but, if not,
they emerge from out of nowhere. This makes terrorism
distinct from all other forms of geopolitical risk, which have
a certain degree of foreshadowing and, although still a low
probability, are not completely off the radar screen. Non-
state actors, having splintered off from society to form Fig. CS11: Comparison of US annual fatality risks
their own factions and cells, are currently planning the next
major terrorist attack. This is certain. Everything else is not. Hazard Period Total fatalities Annual
for the period fatality risk
According to John Mueller and Mark Stewart in the April Cancers 2009 560,000 1 in 540
2010 edition of Foreign Affairs, the risk of a person being All accidents 2007 119,000 1 in 2,500
killed in a terrorist attack is substantially lower than the risk Traffic accidents 2008 34,017 1 in 8,000
of homicide and being in a fatal traffic accident (see Fig. Homicide 2006 14,180 1 in 22,000
CS11). Being struck and killed by lightning is about as likely
Industrial accidents 2007 5,657 1 in 53,000
as being killed in a terrorist attack. Exceptions of course are
countries ravaged by war and regional conflict. As a conse- Terrorism (single year) 2001 2,982 1 in 101,000
quence, most people – including investors – ignore it until Natural disasters 1999-2008 6,294 1 in 480,000
it surfaces. Drowning in bathtub 2003 320 1 in 950,000
Home appliances Yearly average 200 1 in 1,500,000
The principal question regarding terrorist attacks is Deer accidents 2006 150 1 in 2,000,000
whether an event undermines vital infrastructure. While
Commercial aviation 1989-2007 1,955 1 in 2,900,000
each terrorist incident has tragic consequences for anyone
Terrorism (multiple years) 1970-2007 3,292 1 in 3,500,000
caught in the attack, the attacks themselves typically do
not undermine the broader economy and financial mar- Lightning 1999-2008 424 1 in 7,000,000
kets. Only when an attack wipes out critical infrastructure Source: Mueller and Stewart (2010)

Case studies
Case studies
Income inequality
The future of the EMU: until stress do Inflationary quick fix

Since its inception in 1998, the European Central Bank
us part (ECB) had only one objective: to maintain price stability in
the Eurozone. However, on 9 May, the ECB announced
The danger from within that it would buy debt of distressed European govern-
Public finances in the European Economic and Monetary ments, a course of action that its president, Jean-Claude
Union (EMU) deteriorated sharply in the wake of the global Trichet, had denied just three days earlier. While this policy,
financial crisis. For the EMU as a whole, the debt-to-GDP known as quantitative easing, is not fundamentally flawed
ratio has risen to about 85% from 65% in 2007, but the in itself – the US Federal Reserve Bank and the Bank of
situation varies widely across countries and is worst in England have undertaken similar measures – the ECB's
Ireland, Spain, Portugal and Greece (see Fig. CS12). In abrupt reversal called into question whether inflation-fight-
Greece, the deficit jumped to nearly 13% of GDP in 2009 ing remained its top priority. Given that perceptions and
and the debt-to-GDP ratio is fast approaching 130%, symbols are as important to monetary policy as effective
spreading uncertainty over the long-term sustainability of policy measures, this change of course has definitely left
the EMU (see Fig. CS13). market participants puzzled about what type of currency
the euro has become.
Greece has a fiscal problem but the bigger worry surrounds
its current account deficit of 11% of annual GDP. Greece’s Any country with high fiscal debt and a trade deficit may
private sector is uncompetitive and the economy suffers seek to improve its circumstances by expanding the money
from a wide range of inefficiencies, mostly of a regulatory supply, which would weaken the exchange rate and gener-
and institutional nature. Greece is not alone. Ten of the 16 ate inflation. The weaker exchange rate helps to restore
EMU countries are currently running twin deficits – that is, international price competitiveness and thereby reduces
government and current account deficits (see Fig. CS14). the trade deficit. Inflation erodes the value of money and
Barring significant and sustained efforts to improve exter- therefore lowers the real value of the debt burden.
nal competitiveness, reduce public spending and increase Although the EMU countries do not have any national cur-
tax revenue, the stability of the euro will remain in question. rencies and have effectively relinquished control over all
monetary affairs to the ECB, the recent bailout package
While the Greek debt crisis would probably not fit most raises the risk of higher inflation down the road and cre-
market participants’ definition of a geopolitical threat, the ates severe tensions among the member states.
entire Eurozone is a political construct – as is the euro
itself. Many of the issues facing member states are as
much about political choices as they are about economic
ones. The inability of the European Union thus far to reach
a durable political solution to the Greek debt crisis suggests
that the region’s fiscal problems remain a risk and feeds
speculation that the currency union will break apart.
Fig. CS12: Uneven erosion in debt ratios within EMU Fig. CS13: Diversity of fiscal positions within EMU
Change in debt as a share of GDP between 2004 and 2008, in % Public debt versus fiscal deficit as a share of GDP, in %, 2009
160 120 Debt Italy Greece
140
120 100 Belgium
100
EMU Portugal
80 80
60 Germany
Austria France Ireland
40 60
20 Netherlands Spain
0 40 Finland
-20
Netherl.
Germany
Slovakia
Austria
Sweden
EMU
Finland
Italy
France
Belgium
Greece
Portugal
Spain
UK
Ireland
20
Luxembourg Deficit
0
Household debt/GDP Public debt/GDP 0 3 6 9 12 15
Non-financial company debt/GDP Total debt/GDP
Source: Organization for Economic Cooperation and Development Source: Organization for Economic Cooperation and Development

Possible scenarios for the euro be acceptable. Hence, Germany and other inflation-averse
If the twin-deficit countries fail to implement decisive countries could eventually turn their backs on the union.
reforms, the imbalances within the EMU will eventually Moreover, likely debates over the redistribution of
grow wider, threatening the stability of the euro area. resources could fuel political extremism and nationalist ten-
Essentially, we see three scenarios of where the situation dencies that could eventually threaten the cohesion of the
can head from here: union. Overall, while the “muddling through” scenario
seems likely, it leaves the long-run sustainability of the euro
The first option involves greater fiscal and social integra- in doubt.
tion of the EMU member states. While this scenario is the
most positive for the euro, it is also the least plausible. Breakup of the EMU
National animosities coupled with rising inflation could
The second and perhaps next most likely outcome is a eventually lead to disintegration – initiated possibly by infla-
breakup of the euro, precipitated by either Greece or tion-averse core countries. The opposite extreme would be
Germany deciding to exit the currency union. However, disintegration starting in one or more of the peripheral
this decision carries costs for both countries. If Greece twin-deficit countries. In this case it is not inflation, but
left the Eurozone, it would have to introduce a new cur- rather deflation, that becomes the ultimate trigger.
rency that few would initially want to hold. If Germany With currency devaluation and inflation unavailable as
left, the German export sector would lose competitive- tools for individual states to regain competitiveness, the
ness versus the remaining Eurozone countries and only other options to bring economies back into balance
euro-denominated assets held in Germany would likely are to raise income taxes, cut public spending and slash
lose value. wages and prices. Such a deflationary policy path would
no doubt be very painful in terms of lost output and
A “muddling though” scenario appears most likely for employment. After some years of suffering, popular opin-
now, but it would also imply repeated rescue packages ion may turn against the austerity policy of the govern-
for countries that get into fiscal trouble, not to mention ment. Voters could conclude that the costs of leaving the
a highly volatile currency union and prospects for higher EMU may not be that bad compared to the hardship of
inflation. remaining a member state.
Muddling through Unfortunately, it is not possible to predict with precision

Recurring financial bailouts and transfers may eventually how the situation with the EMU will evolve. At the
have to be financed through an expansion of the money moment, fiscal bailouts and austerity policies are steering
supply, which in turn would bring about higher price infla- the union in a new direction. Decisive market-oriented
tion. Fiscal sovereignty would eventually gravitate towards reforms are needed to enhance competitiveness in the
the center of the EMU. The credit ratings and financing twin-deficit countries. However, this takes time and public
costs of the individual states would start to converge until opinion is against such a solution. Thus, at this point, it is
differences were all but eliminated. For some countries, difficult to be optimistic about the future prospects of the
most notably Germany, such a development would hardly EMU (see Fig. CS15).
Fig. CS14: Many EMU countries have “twin deficits” Fig. CS15: EURUSD priced for enduring stability
Fiscal deficit versus current account balance as a share of GDP, in %, 2009 EURUSD exchange rate versus purchasing power parity (PPP)
1.6
0
-2 Finland 1.4
Germany
Italy Austria
-4 1.2
Fiscal balance
Slovenia Netherlands
-6
Belgium Slovakia 1.0
-8 Portugal
France
-10 0.8
Spain
-12 Current Current
Greece Ireland 0.6
account deficit account surplus
-14 1975 1980 1985 1990 1995 2000 2005 2010
-14 -12 -10 -8 -6 -4 -2 0 2 4 6 8
Current account EURUSD EURUSD PPP
Source: Organization for Economic Cooperation and Development Source: Bloomberg, Thomson Financial

Case studies
Case studies
Income inequality
Raising barriers: the allure of trade China-bashing on both sides of the Atlantic
US and EU policymakers have long accused China of keep-
protectionism ing its currency undervalued and selling its products too
cheaply in the global marketplace, thereby causing the
Protectionist reflexes escalation of large global imbalances. Several US legislative
After rising steadily for years, trade volumes slumped dra- initiatives have attempted to offset the perceived competi-
matically during 2008 and 2009, primarily because of tive disadvantage, including a recently proposed bill to per-
reduced demand and tight credit conditions, but also mit tariffs on imports from economies with “fundamentally
because of newly introduced protectionist measures (see misaligned currencies.” China is also a main target of
Fig. CS16). The immediate impact of these actions may be advanced economies’ anti-dumping duties.
limited; however, it raises concerns about the potential for
future trade conflicts. An escalation of the already tense situation could, for
instance, be triggered if Congress passes legislation that
Industries that could stand to benefit from protectionism directly attacks Chinese-manufactured products. China
are likely to lobby for new measures, especially during would be able to retaliate simply by indicating its intention
times of economic stress. Although a country’s trade bal- to reduce its holdings of US Treasury securities and other
ance would likely improve as an immediate result of the dollar-denominated assets, which would alarm financial
trade restrictions, the boost would be short-lived as trading markets, hurt the US dollar and impair the overall econ-
partners would quickly retaliate. Tit-for-tat trade hostilities omy. And China has more scope for retaliatory action after
reduce long-term economic growth potential, create high reducing its dependency on the US as a trading partner. In
adjustment costs for corporations and society and tend to general, emerging markets have taken a much more active
depress financial returns in affected sectors. role in lodging trade disputes with the WTO to address
what they perceive as unfair protectionism, but they could
Income inequality and domestic politics also take retaliatory measures of their own.
Despite the benefits of free trade, there are losers from
trade openness, such as workers in uncompetitive indus- Beware a potential escalation
tries producing goods at higher costs than are available While multinational companies with interconnected global
overseas. If displaced workers are unable to find, or be supply chains will likely act as a counterweight to anti-
retrained for, employment in other industries, trade expan- trade measures as they seek to protect their business
sion may contribute to domestic income inequality. If the model, the risk of protectionism has increased given the
economic recovery proceeds more slowly than expected high level of unemployment, weak economic growth
and does not lead to a significant reduction in unemploy- prospects, widespread income inequality and generally
ment, populist pressures to raise trade barriers will diminished political support for free trade. Any bold meas-
likely increase (see Fig. CS17). The world’s three largest ures that limit trade in products and services or complicate
importers and exporters – the EU, the US and China – the operations of offshore subsidiaries of global companies
already have a number of trade disputes brewing will likely cause angry reactions and retaliation. The nega-
(see Fig. CS18). tive effects on the global economy and risky assets could
Fig. CS16: The trade slump Fig. CS17: Swollen ranks of the unemployed
Annual change in global goods and services trade volume, in % Unemployment rate in OECD member countries, in %
18 10
12 9
6 8
0 7
–6 6
–12 5
1970 1975 1980 1985 1990 1995 2000 2005 2010 1988 1994 2000 2006 2012
Source: International Monetary Fund Source: Organization for Economic Cooperation and Development

be substantial precisely because investors view the mantras industries, such as technology and natural resources. As
of globalization and continued strong emerging market free trade loses momentum along with free market
growth as givens and have uncritically dismissed the risks capitalism, the state could become an important factor in
to the status quo. determining the industry winners and losers – both at
home and abroad.
Protectionism by stealth
Protectionist rhetoric and policies have recently been on
the rise. Rather than explicitly increasing tariffs, however,
governments have taken a more subtle approach in order
to support domestic industries and discourage imports (see
Fig. CS19). For instance, a preliminary version of the 2009
US fiscal stimulus package contained a “Buy American”
clause, which would have required public construction
projects to use US-sourced iron and steel. Germany, the US
and France provided substantial direct and indirect support
to their domestic automobile industries through car-scrap-
ping schemes. Some emerging markets, including Russia,
increased import tariffs to bolster domestic production.
Enforcing product standards and other regulatory barriers

have also become a more widely used technique to restrict
trade in some goods. While many of the concerns have a
legitimate basis, they may also be used as a pretense for
protectionism. For instance, President Obama repeatedly
underlined his intention to enforce environmental and
labor standards contained within the nation’s various trade
agreements. The EU has imposed a number of restrictions
on the basis of health concerns and product safety, includ-
ing import bans on genetically modified agricultural prod-
ucts. Such stealth protectionism could increase in impor-
tance as countries seek to restrict imports without resorting
to explicit tariff measures.
In an April 2010 Barron’s interview, political scientist Ian

Bremmer argues that another form of stealth protection
will emerge whereby states will complicate the business
plans of multinational companies in strategically sensitive
Fig. CS18: The big trading powers Fig. CS19: Protectionism toolbox
Leading exporters and importers in global merchandise trade, in % of world, 2008
Exporters in % Importers in % Type Example

EU 15.9 EU 18.3 Tariffs, quotas and bans Chinese tire tariffs
China 11.8 US 17.4 Environmental, fair labor and Climate change considerations
US 10.6 China 9.1 product safety standards
Japan 6.5 Japan 6.1 Domestic sourcing requirements “Buy American” provisions
Russia 3.9 South Korea 3.5 Subsidies, tax rebates and sector bailouts Car scrapping schemes, direct loans
Canada 3.8 Canada 3.4 Exchange rate devaluation Chinese yuan
South Korea 3.5 Hong Kong 3.2 Migration restrictions Immigration limits based on skill level
Hong Kong 3.1 Mexico 2.6
Singapore 2.8 Singapore 2.6
Saudi Arabia 2.6 India 2.4
Note: EU figures exclude intra-EU trade.
Source: World Trade Organization Source: UBS WMR

Chapter 2
Geopolitical risk
in a portfolio context
Geopolitics interacts with other risk sources in a portfolio. Diversification and ongoing
risk assessment are important precautionary measures to limit losses, but how one
reacts to the shock of a geopolitical event can be just as important, if not more so.
Geopolitics as a source of risk Likewise, geopolitical events can become a source of credit
Chapter 1 outlined a framework to help explain how risk when they raise the potential for default, loss of princi-
geopolitical events affect financial asset prices. While these pal or missed interest payments. For example, a sovereign
insights are essential for investment decisions, this is only state may decide to expropriate private property or nation-
a general guide for how to navigate financial markets in alize private companies. Such measures may, in some
the face of geopolitical uncertainty. This chapter expands cases, be aimed directly at foreigners, especially when
on the framework and highlights how an investment geopolitical tensions are rising. A sovereign default and a
portfolio can be managed to incorporate geopolitical risk suspension of currency convertibility are further examples
considerations. of actions that governments may take that would amount
to a credit event from the perspective of a foreign investor.
From a portfolio construction perspective, dealing with
geopolitics is largely an exercise in risk management. Liquidity risk represents the inability to buy and sell invest-
Geopolitical events are yet another source of risk and ments at prevailing market prices. It, too, can be the result
uncertainty affecting investment performance. It is impor- of policy decisions in a geopolitically charged context.
tant when thinking about the role of geopolitical risk to Examples would include the imposition of taxes on interna-
keep in mind how it relates to the main categories of tional financial transactions and other restrictions on capi-
financial risk, namely market risk, credit risk and liquidity tal flows.
risk. We believe that geopolitical risk is best viewed as a
driver of these broad risk categories (see Fig. 2.1). These observations should help to illustrate that geopoliti-
cal risk cannot easily be pinpointed from a portfolio
Consider market risk, which is commonly used to refer to investment perspective. It will rather affect investors in
the volatility of financial market prices. Phases of height- a variety of sometimes interrelated ways. However, its
ened geopolitical uncertainty are usually associated with impact on portfolios can be broken down into traditional
higher financial market volatility, and therefore geopolitical concepts of risk.
risk is a source of market risk.
Fig. 2.1: Geopolitical risk is a driver of other risks Fig. 2.2: Distribution of “catastrophic” and “ordinary” risks
Impact versus probability grid
high
Geopolitical
Magnitude of impact
Market risk shock
Geopolitical
Geopolitical risk Credit risk noise
low
low Probability of occurrence high
Liquidity risk Catastrophic risks – in many cases shock-based, and unpredictable
Significant risks – can be mitigated with difficulty
Insignificant risks – happen often, predictable and mitigable
Source: UBS WMR Source: UBS WMR

Uncertain but highly relevant to be rare but have a very large impact. It is therefore
As discussed in Chapter 1, geopolitical risk gives rise to important to incorporate some degree of geopolitical risk
events that are either positive or negative for the outlook, analysis into one’s investment framework.
whereby the focus is usually on the adverse consequences
of geopolitical risk. There exists a broad spectrum of Given the characteristics of geopolitical risk and its impact
adverse geopolitical risks, ranging from what one would on financial asset prices, what approach should investors
call geopolitical “noise” at one extreme to the unpre- adopt to deal with it?
dictable geopolitical “shocks” at the other (see Fig. 2.2).
Geopolitical noise tends to be more or less priced in to Limits of a zero-tolerance approach
financial markets, whereas geopolitical shocks are often One strategy is to adopt a zero-tolerance approach to
major market-moving events (see Fig. 2.3). geopolitical risk. This would involve staying out of invest-
ments that are deemed exposed to geopolitical risk of a fat
The noise variety would be associated with frequent skir- tail nature. The problem with such an approach is that if
mishes among nations that ultimately have little impact on taken too literally, it can have prohibitive opportunity costs
economies and financial markets. The geopolitical shocks (that is, foregone return opportunities). Indeed, most
are low-probability, high-impact events often deemed extreme risk scenarios that one can conceive of never
unthinkable before the fact. However, once they material- materialize. Therefore, staying out of risky assets until
ize, they appear easily rationalized in hindsight. It has geopolitical risk has subsided will typically lead to lower
become customary to refer to these risks as tail risk as they returns over the long run because investors will miss relief
lead to outcomes in the “tails” of the statistical distribution rallies after markets undershoot.
of outcomes (see Fig. 2.4). Geopolitical shocks would ulti-
mately have a profound and lasting impact on financial Ultimately, a key reason why equity markets earn a greater
markets. return than less risky assets over long time periods is that
they compensate investors for bearing the risk of being
The difficulty for investors is that it is not easy to distin- exposed to the numerous potential adverse scenarios that,
guish between noise and an unfolding game-changing in the end, do not occur.
event. Full-blown geopolitical conflicts take a while to play
out. At each stage of the process, it is not necessarily clear A framework for investors
whether further escalation is avoidable, a peaceful resolu- We believe that investors are better served by following a
tion is possible or outright confrontation will result. There- more pragmatic approach based on the following steps
fore, when financial markets are hit by adverse geopolitical (see Fig. 2.5):
news that later turns out to be noise (that is, insignificant
or short-lived), markets often undershoot until it becomes Diversification across countries and assets
clear that the situation is benign.
Ongoing risk assessment
The difficulty in dealing with geopolitical risk in a portfolio
investment context is that most geopolitical events belong Managing exposure
to the noise category, but this is only known in hindsight.
However, it would be wrong to conclude that geopolitical Tactical investing
risk can be safely ignored. The really severe cases are likely
Fig. 2.3: Markets upended by high-impact, unlikely events Fig. 2.4: Tail risk illustrated
Impact versus probability grid Frequency versus outcome
high high
Major Rare
market Tail of the
mover distribution
Magnitude of impact
Frequency
Priced in /
minor
Irrelevant impact
low low
low Probability of occurrence high negative Outcome positive
Source: UBS WMR Source: UBS WMR

Chapter 2
Diversification across countries and assets toward safe haven assets. So diversification is not limited to
The benefits of diversification have been touted for so long a broader global footprint but also essentially to a mix of
that their mere mention can make investors yawn. Yet we assets within markets that represent natural hedges.
believe that geopolitical risks are precisely a topic for which
diversification matters a great deal. In fact, geopolitical risk Ongoing risk assessment
may represent the best “real world” justification for diver- Assuming a well-diversified portfolio as a starting point,
sifying a portfolio, as well as the best practical basis for investment outcomes can, in our opinion, be improved if
why diversification works (that is, the returns of different one relies on solid research and risk analysis capabilities.
types of assets are not perfectly correlated over time). The risk assessment process would ideally include the fol-
lowing steps:
Many instances of geopolitical risk are limited to individual
countries or groups of countries without further ramifica- Issue monitoring. This stage involves maintaining a list
tions. While the consequences of tension or conflict may of current and potential future geopolitical issues, such
be significant for those involved, spillovers onto other geo- as a brewing trade conflict between two nations and
graphical areas are often quite limited, as are the cross- keeping up to date. Our goal with the various case stud-
country financial market repercussions. Hence, a broadly ies was to give an overview of the major geopolitical hot
diversified international portfolio is likely to be more resist- spots and to categorize them according to the type of
ant to geopolitical risk than one concentrated in an individ- stress that would ultimately give rise to future shocks.
ual country.
Scenario analysis. Once the main issues have been
There are limits to the benefits of diversification that can determined, it is useful to map out possible scenarios for
be achieved, however. To the extent that a geopolitical cri- how they will evolve and attach a probability assess-
sis takes on a significant international dimension, a high
degree of correlation across markets may result, making it
difficult to fully escape being exposed to such events (see
Fig. 2.6 and Fig. 2.7). Such instances would include ten-
Fig. 2.5: Investment framework for geopolitical risk
sions that lead to a crisis in energy provision, as well as
conflicts involving major world powers. In these and other
more localized cases, the effects are likely to vary across
countries and markets (see Fig. 2.8). Therefore, diversifica-
tion can help limit the exposure to such shocks. Overall, we
stress that diversification should be viewed as a risk reduc-
tion strategy, not a risk elimination solution. Risk Managing Tactical
Diversification
assessment exposure investing
Keep in mind, of course, that diversification entails not just
diversifying across geographic regions but also outside of
“risky” assets. For example, during periods of significant
geopolitical stress, equity markets across the world may
plunge in tandem, yet high-quality government bond hold-
Source: UBS WMR
ings would likely hold value or even rally as capital flees
Fig. 2.6: Oil shock kept equities under pressure Fig. 2.7: Mixed reaction to the Persian Gulf War
Equity price index (Jan 1990 = 100) Oil and gold price index (Jan 1990 = 100) Equity price index (Jan 1990 = 100) Oil and gold price index (Jan 1990 = 100)
120 600 160 200
140 180
100 500
120 160
80 400 100 140
60 300 80 120
60 100
40 200
40 80
20 100 60
20
0 0 0 40
1973 1974 1975 1976 1977 1978 1990 1991 1992 1993
S&P 500 FTSE DAX S&P 500 FTSE DAX

Nikkei 225 Crude oil (rhs) Gold (rhs) Nikkei 225 Crude oil (rhs) Gold (rhs)
Source: Bloomberg Source: Bloomberg

ment. This assessment, too, must be updated on a regu- ment from a loss of any kind but rather on insulating it
lar basis. The first two steps must rely on a thorough against losses beyond a maximum threshold. In other
understanding of geopolitics. words, the aim is to reduce exposure to tail risk. This can
be achieved, for example, by purchasing out-of-the-money
Exposure assessment. The next step is to determine put options on selected equity or currency markets. This
the exposure of various asset classes, regions and sectors provides low-cost protection, since the protection does not
to the main scenarios. This stage must rely on the set in for smaller market moves. One consideration to keep
insights from Chapter 1 about the impact of geopolitical in mind when thinking about tail risk, however, is counter-
events on the economy and financial markets through party credit risk. There are some extreme events that may
drivers such as growth, inflation, interest rates and risk have ramifications so broad that the protection may not be
premiums. available when needed. This would be the case, for
instance, if a financial meltdown caused the exchange
Risk scoring. The combination of the scenario probabil- where the derivative was purchased to turn insolvent.
ity assessment and the exposure assessment then yields
a qualitative risk score for each geopolitical risk issue. Tactical investing
Geopolitical risk also opens the door for opportunistic
Threshold determination. Finally, risk scoring thresh- or tactical investing for those investors who are sufficiently
olds must be determined to serve as upper limits for tol- nimble.
erable levels of risk beyond which corrective action must
be taken within the investment portfolio. Capitalize on underappreciated or overemphasized
risks
Managing exposure The key insight needed here is that financial market prices
Once investors have systematically determined which risks implicitly reflect a collective assessment of the probabilities
they are unwilling to fully bear, the next step is to manage of various outcomes. In some circumstances, it is possible
the portfolio’s exposure to those risks. to back out what these probability assessments are. If an
investor, relying on superior expertise, believes that these
Exit markets implied probabilities are over- or understated, this creates
The first approach is simply to exit a market altogether, or a trading opportunity. The assumption is that at some
to partially reduce exposure. later point, the market’s assessment will converge to the
investor’s assessment, which then leads to a market
Hedging repricing.
An alternative to exiting markets is to retain an existing
position but to hedge the risk exposure with options, For example, consider the case where financial market par-
futures or structured products. This can often be a more ticipants believe that a particular country will default on its
effective way of reducing risk exposure, especially when external debt, pushing credit spreads wider. If an investor is
the objective is downside protection for a limited period convinced that the country is in fact very unlikely to
of time. default, then the assumption is that credit spreads will nar-
row in the future. An investment in the country’s debt
Managing tail risk represents a variation on hedging, would be a simple way to capitalize on such an insight. The
where the focus is not so much on protecting an invest- opposite situation is also possible if the investor believes
Fig. 2.8: Localized weakness as a result of Taiwan Strait Crisis and Lebanon War
Equity price indexes (January 1995 = 100) Equity price indexes (June 2006 = 100)
200 120
180
110
160
140 100
120 90
100
80
80
60 70
1995 1996 1997 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07
Taiwan Taiex Shanghai Exchange S&P 500 BLOM Beirut Index Tel Aviv 100 S&P 500
Source: Bloomberg

Chapter 2
that a default is more likely than is reflected in the market. financial markets do react and that the initial flight to
The conclusion in this case would be to sell or short the safety flows are usually negative for equity markets and
debt of the country. It is worth noting that this could be a positive for certain commodities markets when resource
profitable trade even if the country does not ultimately supplies are constrained as a result of the event. But the
default. It would be enough for the market to increase its reaction will vary considerably from one specific shock to
assessment of a default scenario at a later point for this the next because: valuations differ over time; the repercus-
trade to generate a profit. sions are not always persistent; and the economic effects
are never preordained. Keep in mind, as well, that the con-
This type of approach can be applied more generally to a text in which events occur also impacts the financial mar-
broad range of financial instruments and situations. We ket reaction. Is the world already headed into a recession?
wish to stress that it requires a rather active approach to Is the shock a “game changer” or is the threat priced in?
investing and access to solid expertise.
Notwithstanding these considerations, we have evaluated
Investments that make sense in baseline and geo- the different types of geopolitical shocks and arrived at
political shock scenarios some standard guidelines that investors can use to triage
The idea behind this strategy is to first determine what their investment portfolio in the event of a geopolitical cri-
assets would perform well under a baseline scenario; one sis (see Fig. 2.9). The important thing to acknowledge is
that excludes a particular geopolitical risk event. In the sec- that different types of geopolitical shocks will result in dif-
ond step, asset implications of the geopolitical shock sce- ferent economic and financial market reactions. There is
nario are assessed and assets are ranked by their relative also a secondary consideration regarding whether the
attractiveness. Any overlap between the two lists points to event is either temporary or persistent. Recall from Chapter
a potential investment opportunity based on both a sound 1 that two game changing geopolitical events had consid-
investment case and in the low-probability, high-impact erably different financial market outcomes: the 9/11 terror-
risk scenario. ist attack had a persistent and negative structural effect on
financial markets, whereas equities quickly rebounded fol-
At the current stage of the global economic recovery, we lowing the Cuban Missile Crisis.
believe that investments in crude oil will likely perform
well, as the world economy continues to expand and push We find that in nearly all of these stylized cases, the effect
oil demand higher. If a Middle East conflict involving Israel of geopolitical events on stocks is negative. For those
and Iran were to emerge, it is very likely that crude oil instances when the reaction is temporary and involves
would further benefit as such tensions would probably flight to safety flows, equity markets have the potential to
constrain world oil supply. Such investments are unlikely to reverse the weakness once the event risk fades. The out-
be very abundant but are certainly worth considering. But come for bonds is less straightforward, largely because the
this depends of course on the geopolitical risk one consid- outcome – inflationary or deflationary, temporary or per-
ers most likely. There are other geopolitical risk scenarios, manent – is unclear. Again, the reversal of temporary safe
such as trade protectionism, a terrorist attack and a haven flows would likely prove negative for bonds when
breakup of the euro, that would likely prove negative for the conditions surrounding the geopolitical event normal-
global economic activity and for commodities prices. ize. However, a sustained global war or resource supply
constraint would likely spell trouble for bonds, whereas a
Reaction to events as important as prevention collapse of the US dollar would likely heavily undermine US
We argue that diversification and an ongoing risk assess- Treasuries. Lastly, hard assets, such as certain commodities
ment are important tools to protect investors from geopo- and gold, would tend to benefit from a resource supply
litical risk before it strikes. But some of the preventive tools shock and a sustained military conflict, but would do
we identified, such as defining probabilities for various poorly in the event of heightened protectionism.
geopolitical events and calculating the associated portfolio
risk exposure to these events, is likely beyond the scope of
most investors. Moreover, even the most astute observers
of geopolitical events will not be able to completely insu-
late their portfolios from geopolitical risk, since the events
often arrive in the form of unanticipated shocks. Hence, it
is just as important that investors consider the possible
economic and financial market outcomes of the various
hot spots were they to erupt into a major crisis. Here again,
we are left with only imperfect tools.
For one, financial market valuation matters a great deal

when a negative geopolitical event surfaces to disrupt the
fundamental investment outlook. We can observe that

Fig. 2.9: Potential economic and financial market outcomes of various geopolitical events
Geopolitical event Potential example Economic outcome Potential “real Temporary / Asset market/ Stocks Bonds Hard assets
world” outcome persistent? location
Resource supply shock Russian energy Slower growth and Major resource short- Persistent Global – – + restricted
embargo higher inflation ages develop resource
Conflict over resources Standoff over resource Localized conflict, Flight to safety flows Temporary Opposing countries – + + restricted
access between China potential resource resource
and India supply interruption
Economic embargo Restrict exports to Iran Reduces economic Weakness limited to Persistent Targeted country – ? ?
activity in targeted targeted state; poten-
state tial for retaliation
Nuclear weapons Iran / North Korea Depends on interna- Flight to safety flows Temporary Global – + ?
access develop nuclear tional reaction; limited
weapons economic impact
Military standoff Escalation of conflict Crisis is eventually Flight to safety flows Temporary Opposing countries – + ?
between South Korea resolved, limited eco-
and North Korea nomic impact
Sustained global war / Broad escalation of mil- Impairs productive Massive casualties; a Persistent Global – – +
nuclear attack itary conflict across the capacity and increases “before” and “after”
globe; use of first-strike fiscal deficits; sharp event
capabilities reduction in global
trade and economic
activity; potential
hyperinflation
Terrorist attack Nuclear or biological Infrastructure is Massive casualties; a Persistent Depends – ? ?

attack impaired, slows “before” and “after”
economic activity, event
regional
Car bomb in Limited economic Flight to safety flows Temporary Global or regional – + ?
Times Square impact
Trade protectionism US / China trade war Sharp reduction in Reversal of Persistent Global – + –
global trade and eco- globalization
nomic activity
Currency crisis US dollar collapse Sharp reduction in Abandon world’s prin- Persistent US – – – commodities
global trade and eco- cipal reserve currency + gold
nomic activity
Global – + – commodities
+ gold
Source: UBS WMR
Should investors hedge the risk of a terrorist attack?

The degree of statistical significance is important when it attacks do not bring cities and countries to a complete stand-
comes to hedging strategies. The fact that there are very few still for long periods of time, the preexisting economic funda-
statistically significant terrorist attacks suggests that investors mentals return as the drivers of stock market performance. In
should not try to protect their portfolio from these events, addition, the fiscal and monetary policy response is usually
even if they think the probability of such an event occurring quite strong when the attack poses a systemic threat to the
in the location where they invest is high. First, only a minor overall economy. Therefore, equity markets should be able to
share of all terrorist attacks has a significant negative impact find the highs that existed before an attack without much
on stock prices. In the majority of cases, the impact on stock delay. The upshot: trying to hedge portfolios against the neg-
prices is indistinguishable from normal market volatility. Sec- ative impact from terrorist attacks might be more costly than
ond, the impact of the ones that are statistically significant the benefit of protection.
tends to fade rather quickly. Logically, since most terrorist

Conclusion
The blind side
Objects in mirror may be closer than they appear 1. Economic stress raises the risk of geopolitical
Geopolitical events can surface from out of nowhere to conflict
blindside an investment portfolio. Although we routinely Since the end of the Cold War, geopolitical risk has
focus on issues that are in our immediate field of vision, never been more relevant to investors, in our view.
new developments that radically alter our perception often Widespread economic dislocations – such as higher
emerge out of left field. While financial markets take their unemployment, pervasive income inequality and more
directional cues from a wide array of factors, geopolitics is government intervention in economic affairs – corrode
one subject that matters a great deal to the investment political stability. This comes at a time of heightened
environment. The trouble with geopolitics, however, is that tension between nations over concerns about natural
it often appears as noise until it suddenly becomes a crisis. resource scarcity, development of military and nuclear
weapons capabilities, trade protectionism and funda-
We think geopolitical event risk has increased substantially mental clashes over ideology.
as a result of critical stress fractures in the world economy.
The sources of stress exist over natural resource needs, 2. Geopolitical events heavily influence long-run
national strategic ambitions, non-state ideological ambi- investment returns
tions and income inequality. To better understand these Over the past century for which data is available, piv-
risks, we mapped out several key geopolitical hot spots otal geopolitical events had a material effect on finan-
that could eventually become unstable and disrupt financial markets. Over a long-term holding period, different
cial markets. But we also acknowledge that this list is not geopolitical experiences created radically different
exhaustive and could shift at any minute. financial market outcomes (see Fig. C1). In our view,
attention to geopolitical risk is increasingly important
Geopolitics is not well understood in an investment con- as investments in emerging markets become more
text, which is why we thought a closer examination of the mainstream.
links between the two fields would yield some interesting
conclusions. In this report, we highlight the following 10 3. Critical question: Does a geopolitical shock impact
key takeaways: economic fundamentals?
Geopolitical events rarely leave a lasting impression on
financial markets without a corresponding effect on
Fig. C1: The effect of geopolitical events on financial markets

Real equity return index for selected countries and regions (1900 = 1), logarithmic scale
World War I World War II OPEC oil embargo 9/11 terrorist attacks
1000
100
10
0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
France Germany US World ex–US
UK Japan World
Source: Dimson, Marsh and Staunton (2002, 2010)

economic activity. The transmission to the broader 9. Geopolitics offers strong “real world” basis for
economy can take many forms: a shift in productive diversification
capacity; a reduction in global trade; an infrastructure We believe that geopolitical risks are precisely a topic
impairment; a resource supply shock; and a structural for which diversification matters a great deal. In fact,
impact on economic growth and inflation. geopolitical risk may represent the best “real world”
justification for diversifying a portfolio, as well as the
4. War has severe consequences for trade and also best practical basis for why diversification works (that
affects neutral countries is, why different types of assets generate different risk-
A study shows that countries at war with each other adjusted returns over time).
see a sustained and massive decline in trade volumes
(Glick and Taylor). Even countries that are not directly 10. Reaction to geopolitical shocks matters as much
involved in the conflict see their trade volumes reduced as advance planning
as a result. This is an important risk to the global econ- Even the most astute observers of geopolitical events
omy given the high degree of trade openness between will not be able to completely insulate their portfolios
nations at present. from geopolitical risk, since the events often arrive in
the form of unanticipated shocks. Hence, it is just as
5. Effect of geopolitical events is at times temporary important that investors consider the possible eco-
and reversible nomic and financial market outcomes of the various
When there is little economic fallout from a geopolitical hot spots were they to erupt into a major crisis.
event, the effect on financial markets is typically short-
lived. The US economy was little changed as a direct
result of the Cuban Missile Crisis and the 1990 Persian
Gulf War. Hence, financial markets reversed direction
as soon as the crisis blew over.
6. Terrorist attacks often have minimal effect on

financial markets
Research concludes that the vast majority of terrorist
attacks are rarely significant events for financial mar-
kets (Carrera and Mussio). Again, the principal reason
for this is that the consequences for the real economy
are often limited. Keep in mind, however, that this is
not always the case.
7. Certain geopolitical shocks, such as 9/11, create

lasting structural breaks
The principal question regarding terrorist attacks is
whether an event undermines vital infrastructure.
While each terrorist incident has tragic consequences
for anyone caught in the attack, the attacks themselves
typically do not undermine the broader economy and
financial markets. Only when an attack wipes out criti-
cal infrastructure like it did in September 2001 does it
carry over to economic activity.
8. Monitoring key global hot spots is important to

limit financial exposure
In our view, geopolitical tensions fall into four broad
thematic categories: natural resource needs; national
strategic ambitions; non-state ideological ambitions;
and income inequality. Each category contains differ-
ent, broad types of geopolitical threats, which them-
selves lead to a variety of financial market outcomes.
Even if the timing and magnitude of the fallout are
uncertain, a thoughtful consideration of the risks can
provide important information to investors.

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Publication details
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Publisher: UBS AG, Wealth Management Research, P.O. Box, CH-8098 Zurich
Editor in chief: Kurt E. Reiman, strategist, UBS Financial Services Inc.
Editor: Marcy Tolkoff, editor, UBS Financial Services Inc.
Authors: Thomas Berner, analyst, UBS Financial Services Inc.; Dirk Faltin, economist, UBS AG;
Stephen Freedman, strategist, UBS Financial Services Inc.; Katherine Klingensmith, analyst, UBS Financial Services Inc.;
David Lefkowitz, strategist, UBS Financial Services Inc.; Kurt E. Reiman, strategist, UBS Financial Services Inc.;
Joseph Anthony Sawe, strategist, UBS Financial Services Inc.; Jenny Weinkopf, strategist, UBS AG
We would like to acknowledge the assitance of Emily Kanefield in preparing this report.
Editorial deadline: 2 July 2010

Project management: Andrea Laumbacher, Paul Leeming
Desktop: George Stilabower, Werner Kuonen, Margrit Oppliger, Linda Sutter
Cover picture: Getty Images
Printer: Fotorotar AG, Egg, Switzerland
Translation: CLS Communication, Basel, Switzerland; 24translate, St Gallen, Switzerland
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Geopolitics: the blind side

Wealth Management Research I July 2010

UBS research focus

Natural resource needs: 17

National strategic ambitions: 20

Non-state ideological ambitions: 23

2 Geopolitics: the blind side

In recent years, however, economic activity and financial

The attempted car bombing in New York’s Times Square,

Geopolitical events shape the economic environment and

As economists, analysts and strategists, we calculate fore-

Andreas Höfert Mike Ryan Kurt E. Reiman

UBS research focus July 2010 3

Geopolitics: the blind side

4 Geopolitics: the blind side

Why geopolitics matters

Geopolitics reconsidered A world at a crossroads

UBS research focus July 2010 5

G7 Advanced economies France Greece Germany Japan

6 Geopolitics: the blind side

Fig. 5: Nuclear weapons states and programs

Country Date of first test Code name Comprehensive Test

UBS research focus July 2010 7

Note: Data for 1991 are unavailable. Energy Metals Food

8 Geopolitics: the blind side

ment decisions, but it should not be ignored. According to

We have developed a framework for incorporating geopo-

Fig. 8: Global imbalances continue

US Oil exporters Germany and Japan

UBS research focus July 2010 9

World War I (1914–18) World War II (1939–48)

10 Geopolitics: the blind side

Source: UBS WMR

S&P 500 FTSE DAX Nikkei 225 S&P 500 DAX

UBS research focus July 2010 11

Fig. 1.6: Transmission of geopolitical shocks to economics

Trade protectionism Persistent

Negative inflation Low inflation High inflation

Source: UBS WMR

12 Geopolitics: the blind side

Fig. 1.7: The varied effects of geopolitical shocks on financial markets

Geopolitical events Impact on assets

UBS research focus July 2010 13

Income inequality. Protectionism is a greater risk when

Colombia India Spain Thailand UK US

14 Geopolitics: the blind side

War: the most devastating geopolitical risk

UBS research focus July 2010 15

Geopolitical hot spots

Global tectonic shifts Common geopolitical themes

Natural resource needs: Non-state ideological ambitions:

National strategic ambitions: Income inequality:

16 Geopolitics: the blind side

Natural resource needs

UBS research focus July 2010 17

Natural resource needs

Consequences of the state's firm grip on the economy

18 Geopolitics: the blind side

Russia will also reap the benefits of higher energy prices,

300 1,800 160 16

UBS research focus July 2010 19

National strategic ambitions

20 Geopolitics: the blind side