Geopolitical tensions and carefree financial markets
Meanings differ about the importance of geopolitical risks to the financial markets. On the one hand, you have the movement that considers that geopolitical risks have no lasting consequences for the financial markets and are therefore unimportant. In this regard the Yom Kippur war of 1973 is the only geopolitical event since WWII that had a lasting impact. This led to the oil embargoes and a structurally-altered oil market. While all other geopolitical happenings (such as 9/11, Tiananmen Square in 1989, the Arab Spring, Iraq’s invasion of Kuwait, the revolution in Iran in 1979 etc.) did lead to a short-lived reaction on the financial markets, they more than recovered within a few months.
In recent times too, the financial markets seem to have been little affected by the geopolitical unrest. The Brexit vote led to much commotion initially: the day after the referendum, most shares indices in the developed economies fell by over 5% and the pound devalued by 8% against the dollar. Bond prices and corporate credit spreads strengthened but the markets recovered rapidly. When Donald Trump was elected, things went even faster: share prices fell sharply in the first instance, but after only a few hours it was realised that the new president could be responsible for lower taxes, more government spending and deregulation in various sectors. The S&P 500 index rose by 5% in the period from 8 November to 31 December, and the STOXX Europe 600 by 8%.
Even now, the markets are not reacting much to recent geopolitical tensions. Missile launches in North Korea, increasing tension between Saudi Arabia and Iran, upcoming elections in Italy and Germany, or President Trump’s domestic political squabbles – none of them has made the markets nervous. This is clear from the development of the primary indicator of uncertainty on the financial market, the VIX index. At times of great uncertainty on the financial markets, this indicator has stood above the 40% point. In May and June of this year, it was actually under the 10% point for some months, a clear signal that the markets were scarcely concerned.
Yet not everyone is so carefree. Professor Eswar Prasad of Cornell University warns that the financial markets tend to underestimate geopolitical risks. In this, he draws particular attention to the consequences of the recent cyber attacks affecting all kinds of businesses and the economic dangers of increasing protectionism. His concern is supported by the Bank for International Settlement (BIS). In its recently-published annual report, the BIS pointed to the discrepancy between geopolitical tensions on the one hand and the low market uncertainty on the other. In this regard, the BIS is looking for a number of signals that the market is starting to factor political risks in differently and is slowly starting to become more nervous. For the BIS, the first signal was the reducing correlation of the yields of the various sectors on the shares market. The reason for this is that recent geopolitical developments have been creating winners and losers on the financial markets. Since Trump’s election success, the financial sector has been characterised as a winner, as a result of the expected interest rate increase and the proposed deregulation. Conversely, the import-intensive sectors have become regarded as losers as a consequence of the contemplated aggressive trade policy. The altered appraisal of the various risks has therefore led to diminishing sectoral correlations of the yields. The same applied to the regional yield correlations. Countries with a close trade relationship with the US saw their exchange rates and share markets weakening in general, while it was expected of other countries that they would in fact profit from the improving world economy. The BIS’s second signal concerned the factoring in by the financial markets of very improbable events – tail events. Here, the BIS pointed to the increases in the CBOE SKEW and RXM indices.
Although the BIS is doing its best to see responses to the geopolitical risks in the financial markets, its arguments come across as a little contrived. Perhaps the argument for the discrepancy between geopolitical tensions and lack of worry on the financial markets needs to be looked for somewhere else entirely. The extraordinarily free monetary policy of recent years – that led to major liquidity in the financial markets and even to negative interest rates – has disrupted many normal market movements and indicators. Risks are therefore not adequately priced under the present extremely lax liquidity ratios. This could also apply to the VIX index. The markets in this case assume that the central banks will mitigate any consequences of geopolitical tensions with facilitating monetary policy and so they remain unconcerned. It happened days after the Brexit vote: the Bank of England lowered its base rate to counter the uncertainty. However, if the normalisation of monetary policy continues and liquidity becomes scarcer, then geopolitical tensions will start to translate better into increasing uncertainty on the financial markets, possibly sooner than expected. In this case, the main thing will be to keep a close eye on the inflation expectations. After all, higher inflation leads to normalisation of monetary policy and therefore to the more adequate pricing of risks, including those of geopolitical tensions.
 Michael Cembalest of J.P. Morgan Asset Management, ‘Geopolitics and Markets: Red Flags Raised by the FED and the BIS on Risk-Taking’; July 2014
 The VIX index is the Chicago Board Options Exchange S&P 500 Implied Volatility Index; standard deviation in percentage points annually. This index conveys the volatility of the prices on the financial markets. High volatility means major deflections in the prices and therefore much uncertainty.
 As an indication: the VIX index has only been below the 10% point nine times since 1990.
 See: https://www.bloomberg.com/news/articles/2017-06-28/cyberattack-is-vivid-example-of-underpriced-threat-prasad-says
 BIS 87th Annual Report, Chapter 2: ‘Political Shocks Reorient Markets’.
 The CBOE SKEW index uses the prices of out-of-the-money options to assess the risk of major drops in the S&P 500. This index has risen sharply in recent months. The RXM, an index of the readiness to take profits from major rises in the S&P, has also risen steeply. This means that the market sees an end to the price rises approaching.