Geopolitical risk seems to have a muted impact on financial markets. The increasing number of parties openly involved in the Syrian conflict could have led to some concerns from an investor perspective—but it did not. Although the headlines related to the Middle East are alarming, the market is shrugging its shoulders: Equity market volatility, as measured by the VIX index, has just experienced a 10th consecutive daily fall—a third such occurrence only in the last decade.
There is a wide range of explanations for this behavior which can be synthesized as follows:[1]
Complexity: Probability, causality, timing, magnitude and impact of a war are all extremely difficult to predict, leading investors to “switch off”, victims of “disaster myopia”
Historical patterns: In the past, conflicts did not have a lasting impact on the stock markets (including, for example, the ‘62 Cuban missile crisis, the ‘67 Six Day War, the ’82 Falklands War, ’91 Kuwait, ’03 Irak and 9/11), which provides some comfort to investors today as they seek not to overreact to geopolitical risk, even when it materializes. The 1973 Israel/Arab conflict is the exception as it led to an energy crisis-driven decline in the economy and the stock market
Amoral bias: Collectively, investors only react to events which impacts the financial “bottom line” (especially through oil prices), putting moral judgment and emotions aside, even when confronted with war atrocities
Rational complacency: Market participants assume that world leaders behave rationally, which is, in their view, consistent with the expectation that conflicts remain contained
Lack of experience: Many market participants cannot appreciate the cost of potential conflicts because they never experienced a real one as a result of a generational change
Illusory change: According to this argument, geopolitical risk may take a different form over time but is inherently constant by nature. It is always there but simply expresses itself in different ways
Risk vs. opportunity: A conflict may represent a path to a better world, so that its costs are offset by the net present value of its future benefits, which should make it “value neutral” if not “value-creating”; and last but not least
Central banks: Under the current circumstances, market participants assume that central banks would successfully support the market during difficult times, including during wartimes
Unfortunately, conflict resolution attempts around the world cannot expect much support, if any, from the financial markets. Higher order values and drivers are required—closer to the heart.
[1] Sources:
“Here’s the most profitable way to trade a geopolitical shock”, Elena Holodny (Business Insider), Jun 17, 2015
Strategy & Geopolitics—“Games countries play and implications for business”, Carlos Primo Braga (IMD), Apr 2015
Geopolitical risk—“The fear and reality for financial markets”, Colin Moore (Columbia Management), Apr 1, 2015
“The rational complacency of financial markets”, Nouriel Roubini (The Guardian), Oct 1, 2014
Outside the box—“Geopolitics and Markets”, John Mauldin (Mauldin Economics), Jul 25, 2014
“Geopolitics & Markets”, Michael Cembalest (JPM research), Jul 21, 2014
“What will happen to shares if the West strikes Syria?”, Richard Tyson (Daily Telegraph), Sep 6, 2013
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