Wednesday, October 8, 2014

Reasons why markets have performed well so far

An increasingly obvious paradox has emerged in global financial markets this year. Despite the fact that geopolitical risks - the Russia-Ukraine conflict, the rise of the Islamic State and growing turmoil across the Middle East, China's territorial disputes with its neighbours and now mass protests in Hong Kong and the risk of a crackdown - have multiplied, markets have remained buoyant, if not downright bubbly.

Indeed, oil prices have been falling, not rising. Global stock markets have, overall, reached new highs. And credit markets show low spreads, while long-term bond yields have fallen in most advanced economies.

Yes, financial markets in troubled countries - for example, Russia's currency, equity and bond markets - have been negatively affected. But the more generalised contagion to global financial markets that geopolitical tensions typically engender has failed to materialise.

Why the indifference? Are investors too complacent or is their apparent lack of concern rational, given that the actual economic and financial impact of current geopolitical risks - at least so far - have been modest?

Global markets have not reacted for several reasons. For starters, central banks in advanced economies - the United States, the Eurozone, the United Kingdom and Japan - are holding policy rates near zero and long-term interest rates have also been kept low. This is boosting the prices of other risky assets, such as equities and credit.

Markets have taken the view that the Russia-Ukraine conflict will remain contained, rather than escalating into a full-scale war. So, though sanctions and counter-sanctions between the West and Russia have increased, they are not causing significant economic and financial damage to the European Union or the US. More importantly, Russia has not cut off natural-gas supplies to Western Europe, which would be a major shock for gas-dependent European Union (EU) economies.

The turmoil in the Middle East has not triggered a massive shock to oil supplies and prices like those that occurred in 1973, 1979 and 1990. On the contrary, there is excess capacity in global oil markets. Iraq may be in trouble, but about 90pc of its oil is produced in the south, near Basra, which is fully under Shia control, or in the north, under the control of the Kurds. Only about 10pc is produced near Mosul, now under the control of the Islamic State.

Finally, the one Middle Eastern conflict that could cause oil prices to spike - a war between Israel and Iran - is a risk that, for now, is contained by ongoing international negotiations with Iran to contain its nuclear program.

So, there appears to be good reasons why global markets have so far reacted benignly to today's geopolitical risks.