Investment Strategies

Financial Markets Shrug Off Geopolitics But For How Long? Asks Citigroup

Tom Burroughes, Group Editor, 24 September 2014

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The ability of countries such as the US to unlock previously hard-to-get energy from the ground by “fracking” and central banks’ ultra-loose monetary policy is preventing an upsurge in geopolitical risks from hitting global markets – at least so far.

The ability of countries such as the US to unlock previously hard-to-get energy from the ground by “fracking” and central banks’ ultra-loose monetary policy is preventing an upsurge in geopolitical risks from hitting global markets – at least so far.

That, at any rate, is one of the main explanations from Citigroup for why events such as clashes in eastern Ukraine or Islamist attacks in northern Iraq have so far not knocked global markets from their perch, the bank said in a regular note, authored by analyst Tina Fordham. Her report is entitled War & Peace: Shale, Central Banks Underpin Investor Indifference to Geopolitics: Financial Markets Have Been Able to Shrug Off Geopolitical Turmoil. Can this last?

"The annexation of Crimea and ISIS’ rejection of the Sykes-Picot borders in the Middle East risk the return of border disputes, largely unseen since WWII. Tensions between Russia and the West have prompted sanctions and a revival of nuclear rhetoric, while the US is expected to authorize air strikes against ISIS in Iraq. These developments are taking place in a more uncertain security environment, compounded by declining defence budgets, reduced public appetite for military intervention and rising anti-establishment sentiment. In the short-term, we think investor indifference to geopolitical risks is largely justified. But given deteriorating security and political fundamentals, and the prospect of waning QE, this is unlikely to last," she said.

Asking why there hasn’t yet been much market impact, she writes: “Historically, geopolitical risks have impacted markets through one of two transmission mechanisms: a growth shock or an oil price shock - or both, as in the 1973 crisis. Today, central bank support has limited the impact of disappointing growth on markets, and the emergence of US shale has muted the impact of an oil price shock, raising the question of whether markets have outsourced geopolitical risks to central banks.”

Emerging markets account for 10 per cent of the market value of global equities, but most investor focus remains on what is happening in the developed economies, so for the time being, the fact that developed markets haven’t priced in the risks is probably justified, she said.

Even so, the potential for such conflicts to have a widening effect cannot be underestimated, Fordham writes. “We see the Russia-Ukraine crisis as having the most potential to become ‘systemic’, as Russia is both a large economy and a major commodity producer. Even with relatively mild sanctions, the `Russia impact' alone is estimated to cut eurozone growth by 0.2-0.3 per cent per annum, and an escalation involving for example disruptions to gas supplies could throw the eurozone economy back into recession.”

Fordham said Citigroup is cautious on whether central bank action and the availability of shale gas supplies can mask geopolitical risk indefinitely. “With QE on the wane and deferred oil prices buttressed by the negative impact of geopolitics on future supplies, the potential for supply dislocations remains significant. Market indifference may also have unintended consequences: while the presence of these buffers limits market disruption and damage to the global economy, it could be contributing to a variation of moral hazard risk for foreign policy, exacerbating the crises at the regional level and raising the threshold for international action,” she said.

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