Trend is not necessarily investors’ friend this time
Markets have been sanguine about geopolitical risk for several years now, a phenomenon illustrated by the relaxed approach they have taken to Ukraine’s crisis. There are understandable reasons for this, but contrary to a popular saying, this could well be a case where the trend is not necessarily the markets’ friend.
After just one day of extreme nervousness, markets have had little problem digesting a major change in the map of eastern Europe. And Crimea’s annexation is not the only notable development in a crisis that has repeatedly surprised quite a few experts.
The situation there now pits Russia against western Europe and the US in a manner more reminiscent of old-fashioned cold war dynamics than modern day diplomacy. The nucleus is a country that is a major east-west conduit for energy supplies. The country’s internal social and political situation is far from stable. And many believe President Vladimir Putin’s ambition may extend to other parts of Ukraine.
After an initial flurry, markets have brushed aside these and previous geopolitical concerns, whether over Iran, Iraq, North Korea or Syria. They are now similarly relaxed about the Turkish government’s tensions, Venezuela’s volatile situation and Thailand’s struggles to fully restore socio-political calm.
There are a number of reasons for this market tranquillity.
Smaller is safer
First, most of the recent turmoil has occurred in countries that, at least on a standalone basis, are systemically small when measured by traditional indicators of contagion – namely, relative size in the global economy, cross-border trade linkages, financial network effects, and technical impact on market positioning.
Second, with no external power being economically – and politically – strong enough to impose its will on others, markets feel there are internal circuit breakers in each situation, limiting the risk of geopolitical over-reach.
Third, after a prolonged economic slowdown in the aftermath of the global financial crisis, North America and western Europe (the world’s two largest economic regions and therefore the most systemic) have been slowly improving. Even Japan has done better.
Fourth, markets continue to have unshakeable faith in central banks’ ability to insulate them from weaker fundamentals, whether economic, financial or political.
Finally, a powerful dose of adaptive expectations and behaviour is acting as a strong reinforcement. After all, markets love consistent trends, and the pattern of quickly fading geopolitical disruptions has been profitable for some time.
There would be little reason to doubt this would continue were it not for the way these political crises are evolving.
While each geopolitical shock has been small on a standalone basis, in aggregate they are starting to affect a more meaningful part of the global economy. And few, if any, can be resolved easily. Meanwhile, leaders in Europe and the US will come under increasing domestic pressure to act more forcefully externally, weakening the circuit breakers.
Institutional weakness
Do not look to global co-operation as a way to diffuse most of today’s geopolitical tensions. Hampered by national politics, the effectiveness of multilateral institutions has failed to keep up with the increasing complexities on the ground.
This weakness could even start playing out in earnest in Ukraine in the next few weeks. All it would take is for additional blatant territorial intervention by Russia to trigger comprehensive financial and economic sanctions by the west. With Russia likely to retaliate by disrupting the supply of energy to western Europe, the world would be thrown into recession, along with renewed financial instability – a situation that would certainly derail capital markets.
While a notable risk, this is not the most likely scenario for the next few weeks. Instead, the situation is likely to stabilise temporarily at a new geopolitical equilibrium, albeit a fragile one, in which the west tolerates the annexation of Crimea and Russia’s “legitimate interests” there, while Russia pays lip service to Ukrainian territorial integrity and supports international help for the country while deferring some of its own claims.
Should this indeed materialise, markets would again feel vindicated in having responded rather calmly to the Crimea crisis. Yet they should guard against complacency based on a simple extrapolation of the past. Underlying geopolitical tensions around the world have been gradually building towards a tipping point. Should this continue, it would quickly become evident that many markets are underpricing geopolitical risk.