Markets Versus Geopolitics – Keep Your Eye On War Premiums

Hamas, Israel, Russia, Ukraine – just sabre-rattling, or should we be worried in the long term?

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Rachael Revesz
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Editor, etf.com Europe
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Reviewed by: Rachael Revesz
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Edited by: Rachael Revesz

 

The MSCI World Index is up almost 16 percent this year, the U.S. is celebrating a six year bull run, while emerging markets stocks are climbing around 7.5 percent so far in 2014.

But wait, was that another travel disaster in the news? How many more people have been killed in Gaza this week?

The Global Peace Index, published in June by the Institute for Economics and Peace, found that global security has worsened every year since 2008, with 111 countries becoming less safe and only 51 countries improving.

There is so much bad news that investors might be tempted to pull the covers over their head or cancel that holiday plane trip, yet stock markets are bounding towards the sky.

And given that markets are driven to a large extent by irrational human sentiment, why are equities and bonds still going up?

Don’t get me wrong; it’s not all plain sailing. Investors are still second-guessing the nature and length of the rally, calculating the perfect time to take their profits and leave the party.

Some point to “stretched valuations” of technology stocks , others frown over inflated prices in the UK housing market, while others keep a constant eye on bond yields or fret over the massive amount of debt we would face if interest rates were hiked by just a few basis points.

Yet other investors say we have not even reached record highs, we are actually at historical averages in the market, so why not enjoy the ride?

The fact is we will never be able to predict exactly when, or if, a market correction will happen. But two things seem certain: geopolitical risks do not seem to have a long term effect, at least based on history, and second, crude oil is a good proxy for measuring the real effect of geopolitical risk.

Sure, over the past few weeks, as we were bombarded with bad news in Russia, Ukraine and Israel, investors were heading for safe havens, playing the price dip on oil and gold, and exiting high yield.

But that doesn’t mask the fact that emerging markets and high yield assets have seen phenomenal growth this year.

ETF strategists have said investors should not panic. In an article published on the U.S. site of ETF.com this week, James Breech, president and chief executive officer of Toronto-based Cougar Global Investments, said recent nervousness is just “sabre rattling” and our eyes should be on oil and gas.

John Forlines III, chairman and chief investment officer of N.Y.-based JAForlines Global, advised investors to ignore the noisy headlines in the news because there is no real evidence of market disruption.

Finally, Hafeez Esmail, director of marketing at San Francisco-based Main Management, said not to worry too much about a market correction as end-of-year returns still look good.

But what about the fact that we are in a changing world, where we can’t use history to forecast the unknown?

Steen Jakobsen, chief economist and chief investment officer at Saxo Bank, wrote in a fascinating blog post this week that he has to factor in the risk of wars as they are intensifying and the number of casualties is increasing.

Jakobsen measures the risk of war by measuring the spread between the fifth contract of WTI crude oil and the first contract. Since 15 July the so-called “war premium” has increased by $2 per barrel.

“The overall impact from war is negative despite the glorified analysis of how World War II stopped the recession – think of the 1970s – probably a better and more relevant analogy to today’s trouble in Gaza, Iraq, Russia/Ukraine, Libya, and Syria,” he wrote.

Many will argue things were different then when we were more dependent on the Middle East, but Jakobsen reminded us that oil prices were around $10 to $25 per barrel.

Jakobsen warned that economic events tend to have a delayed reaction of nine to 12 months, and he bets on higher energy prices having a serious impact on world growth and on markets.

Have we been fooled into thinking the real world doesn’t matter? Do we believe zero interest rates will save us? It seems most appropriate for Jakobsen to sum up:

“We need to accept that the world is now truly global – we smiled while globalisation reduced prices and made our companies more profit, now the escalation of wars reflect a world where growth is low, energy is expensive and increasingly hard to get and that we have gone full circle with macro and interventionist policies.”

Rachael Revesz

Rachael Revesz joined etf.com in August 2013 as staff writer. Previously an investment reporter at Citywire, she has a background in writing content for retail financial advisors and has covered a wide range of subjects in finance. Revesz studied journalism at PMA Media, which has since merged with the Press Association. She also holds a B.A. in modern languages from Durham University, as well as CF1 and CF2 financial planning certificates from the CII.