Investors seem to be living in a world that is much more stable, politically, than the real one. Late last week, America’s S&P 500 index hit a new intra-day record and European equities posted their first weekly rise in a month.
Markets shrugged off the Ukraine crisis and Janet Yellen’s debut. Trading was choppy early this week, but optimism still prevails.
This resilience is starting to look complacent, says Nicholas Spiro of Spiro Sovereign Strategy. “No sooner does a risk event emerge than markets brush it off after a brief period of nervousness.” Yet, while markets cling to their “glass-half-full view”, the “half-empty part is becoming more and more difficult to ignore”.
Historically low interest rates and money printing are key reasons for this. China’s attempt to tame the credit boom and the slowdown in major emerging markets are also nothing new. But a more recent phenomenon is that equities appear to be pricing in a great deal of political stability, even though there is less and less of it about.
As Mohamed El-Erian notes in the FT, markets rapidly overcame jitters over Iran, Syria and North Korea, and more recently they have been “similarly relaxed about the Turkish government’s tensions, Venezuela’s volatile situation and Thailand’s struggles fully to restore socio-political calm”. Each geopolitical shock has been relatively small, but in total they are beginning to undermine more and more of the global economy.
The Ukraine crisis could lead to a global recession and financial turmoil, says El-Erian. If Russia invades the rest of Ukraine, it would trigger much tighter financial and economic sanctions by the West. Russia could well retaliate by cutting off energy supplies. This may not be the most likely scenario, but it is a “notable risk”.
Markets certainly don’t have an unblemished track record when it comes to pricing in political risk, as Gluskin Sheff’s David Rosenberg points out.
When Hitler invaded Austria and Czechoslovakia in the spring of 1938, the Dow Jones index slipped to 113 by April, down from 126 in February. But by November the Dow was back to 152, because investors reckoned the crisis was over. The market’s response was “no different to today’s calm”.