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Watch what markets don't do as world politics turns nasty
Started:July 23rd, 2014 (08:48 PM) by kbit Views / Replies:121 / 0
Last Reply:July 23rd, 2014 (08:48 PM) Attachments:0

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Watch what markets don't do as world politics turns nasty

Old July 23rd, 2014, 08:48 PM   #1 (permalink)
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Watch what markets don't do as world politics turns nasty

Like so much in the investment world of late, it's what financial markets are not doing right now that is most intriguing.

Over the course of the past month, conflicts, superpower standoffs and economic sanctions have flared in Iraq and Syria, Israel and Gaza, Ukraine and Russia. All are at least potential threats to world energy supplies, if not globalized business links and supply chains.

What's more, a September referendum looms on the potential breakup of the world's sixth largest economy as Scots vote on secession from the rest of the United Kingdom.

Yet the world's main financial markets have barely blinked.

Crude oil prices gyrated briefly on the upsurge in the Iraq/Syria violence but net moves have been slight to non-existent. At around $108 per barrel, Brent crude is roughly where it was at the start of this year - and where it started last year and even the year before that.

In the face of all this seeming uncertainty, energy price volatility has in fact sunk to its lowest on record.

For some, energy prices moved to discount this more economically integrated but less politically stable globe more than 10 years ago, when they quadrupled in the early 2000s.

And the persistence of $100 plus per barrel oil in itself reflects that more fragile state of affairs. Little of what's happened this year will have materially altered that picture beyond a relatively small $1 or $2 pop in futures markets premia for near-term supply disruptions.

For all that strategists puzzle over the lack of price reaction to last week's downing of a Malaysian airliner over Ukraine, many acknowledge that recent history does not support a view of either spiraling conflict or direct links between political violence and lasting market or economic fallout.

"In my mind, the market is not assigning a high enough probability of this situation escalating to uncomfortable levels but the reality is the most likely outcome is that it doesn't," said Deutsche Bank's Jim Reid.

Even if western sanctions on Russia - the world's eighth largest economy - are ratcheted up and Russian markets are as exposed as their near 10 percent drop over the past 10 days suggests, investors know that seeing through periodic spikes in political tensions would have paid off time and again.

"Russia has oil and gas; it is inconceivable that the West will take any meaningful macro sanctions that would endanger the supply of Russian energy to Europe," said Jim Wood-Smith at Hawksmoor Investment Management. "So there will be all the usual huffing and puffing ... with politicians all hoping everything will have calmed down in a few months."


That may sound too relaxed or even complacent given the stakes at hand. But if wars, coups and conflicts in energy-critical hotspots can't even excite oil prices for more than a few days, then it's hard to see how the wider economic and financial universe would be materially affected.

"The simplest way to measure geopolitical risk is to look at the price of energy. Energy is everything for the macro economist," said Steen Jakobsen, chief economist at Saxo Bank.

The reaction on world equity markets would appear to confirm that. For all the short-term wobbles, world equity indices .MIWD00000PUS are up 0.6 percent for July and 5.6 percent in the black for the year.

As for any dash to "safe" assets such as U.S. Treasury bonds, dollars, gold or Swiss francs, 10-year T-bond yields are down 3 basis points this month but those on two-year paper are up by the same. The dollar has strengthened 1 percent in July, but gold and Swiss francs have fallen almost as much.

But what of other transmission mechanisms from international conflict to the real economy? One potential route would be business or consumer anxiety that crimped spending, hiring or investment due to lack of visibility on demand or job security.

Surveys measuring sentiment will not yet have captured the period since flight MH17 was shot down but there was already a marginal ebbing of euro zone economic sentiment in June from three-year highs.

Some economists point to soft manufacturing data across Europe in May as partly a function of the Russia/Ukraine standoff and the western sanctions imposed on Russian companies after Moscow's annexation of Crimea in March and its subsequent support for separatists in eastern Ukraine.

Europe's dependency on Russian gas, the large relative exposure of German and European companies to the Russian economy and the already fragile state of many euro zone economies does mark it out as a likely underperformer.

That's been borne out by a breakdown in correlation since early July between the Euro STOXX 50 .STOXX50E index of euro zone blue chips and the 4 percentage point outperformance of the Dow Jones Industrial Average .DJI.

But while Russia's already ailing economy and specific western European companies and sectors may be in the firing line, any reading of the global economic disturbance pales in comparison to the weather-related shock of a first-quarter U.S. economic contraction, for example. That's certainly true as long as oil prices remain unimpressed.

Investors will most likely choose to see through sometimes shocking events to more mundane but dominant drivers such as the - currently distorted - U.S. interest rate cycle, and when those rock-bottom interest rates will start to rise.

While that's unlikely to be this year, it's only the volatility associated with that event that would finally see geopolitics and energy prices amplified to the point of impact.

Watch what markets don't do as world politics turns nasty | Reuters

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