In the world of finance, geopolitics has become synonymous with conflict between countries. Just look at Bloomberg, Goldman Sachs or J. P. Morgan. While conflict is an important part of geopolitics, such a view is narrow. In his book Geo-economics, Joachim Klement (we recommend his writings) shows how narrow the thinking about geopolitics has become by pointing to the popularity of the Geopolitical Risk (GPR) index. Created in 2019 by Federal Reserve researchers Dario Caldara and Matteo Iacoviello, the GPR index has become popular as a tool to study the relationship between geopolitics and financial markets. However, the data in the index is based solely on scanning words in Western newspapers to identify mentions of wars, civil wars, and terrorism. This limits the scope of geopolitics to a narrow set of risks.

What investors may be missing is the way in which government policies, in response to conflicts between countries, create new trends in financial markets. These policies fall into two categories: protectionism and autarky. One of our key findings is that while both protectionism and autarky aim to reduce dependence on other countries, only one of them seems to be somewhat effective, and this, perhaps surprisingly, is the more extreme policy of autarky.

Protectionism, which refers to policies that restrict imports from other countries, tends to produce negative outcomes for all concerned. The logic is simple: when the US government imposes tariffs on Chinese imports, for example, it is American consumers who bear the brunt of higher prices, while there's no guarantee that domestic production of similar goods will become more attractive.

Take the example of Brexit, the UK’s protectionist response to its conflict with the European Union. It has led to a multiyear period of underperformance for British equities (before Brexit, the UK outperformed the EU).

More generally, countries that rank lower on the Index of Economic Freedom (in which openness to trade is a key measure) also tend to underperform (as we have shown previously). See the chart below.

Autarky, which refers to policies that create conditions for local production, is different. In fact, it can lead to positive outcomes for the country. Take the US Inflation Reduction Act (IRA) of 2022, which created incentives for American companies to invest in local production of renewable energy (as well as the CHIPS Act of the same year, which created incentives for local production of semiconductors). When these policies are followed by actual investments, a new dynamic can unfold in the financial markets. The graph below shows that infrastructure companies, which benefit from growth in local production, have significantly outperformed the S&P500 since the implementation of the IRA and CHIPS Act in 2022.

Put simply, the difference between protectionism and autarky is who pays the price of de-globalization: domestic consumers (protectionism) or foreign companies (autarky). In the latter case, it is possible (but not necessary) that domestic businesses will benefit.

In conclusion, investors who see geopolitics as the domain of war, conflict and risk have a limited perspective. They should also consider the ways in which governments respond to these conflicts, which include protectionism and autarky. This broader perspective not only illustrates the increasing importance of political decision-making in understanding financial markets, but can also provide potential investment opportunities.