The Thing About Geopolitical Risk


A BETTER WORLD - When you think about all of the geopolitical risk over the past several years, it's been pretty amazing to see risk correlated assets hold up so well during these periods of tension that are intuitively and traditionally risk off. So what's been going on? The simplest explanation is that we live in a relatively stable world where there hasn't been a need to worry about any serious escalation of such threats. And so, while market participants are sensitive to such risk, they aren't as concerned with it as far as their investments go, because they don't believe anything will ever escalate to a level where these portfolios would be vulnerable. 

THE ADDED LAYER - This is all true of course. But at the same time, there has been an added layer of immunity built in when talking about market reaction to geopolitical risk and that layer is one provided by central banks. Since the onset of the financial markets crisis of 2008, central banks have been committed to doing whatever necessary to ensure markets not only remain supported but that markets are given massive incentive to rally. And so, when a central bank tells an investor money is going to be free, with rates going to zero or lower, the investor is forced to adopt a mentality where he's only thinking about buying. This is true to the point where even global terrorism, regional wars and nuclear threats are shrugged off. 

WHEN IT RAINS - But that all could be about to change and here's why. If we are to believe that monetary policy accommodation has contributed to investor immunity to geopolitical risk, it only stands to reason that the removal of such policy will erode the immunity. The Fed has already begun the policy reversal process and the process and discussions are also well underway at the other major central banks. It's true - it's been a very slow process and this is perhaps why we aren't noticing any changes just yet. But I believe those changes are coming and when the come, they will come hard and fast. When it rains, it pours.

THE POLITICS - If we just look at this North Korea provocation as an example, we could easily see a situation where it starts to get a lot uglier a lot faster. It's important to also be aware of the fact that just as monetary policy accommodation had been so helpful to risk markets in recent years, so to was the political accommodation. When I say this, I refer to the previous US administration's take on diplomacy and efforts to prevent any geopolitical risk from ever escalating to a risk off level. But now we have a new US administration with an alternative take on diplomacy and this alternative take could very well result in a scenario where risk markets are needing to pay closer attention.

Investors may no longer be so immune to geopolitical risk going forward. Via @joelkruger

THE NEXT PHASE - The US President has been repeatedly provoked and if this continues, there could be a response the markets won't be feeling too good about. So we have moved into this new phase of the cycle where we are shifting from monetary and political policy accommodation to monetary and political policy tightening. I'm not suggesting that we will see things play out like this over the coming days, but I am proposing the idea that risk markets are vulnerable and not in the same rosy ecosystem that has had these markets carefree and lounging out for nearly a decade. I suspect activity will start to pick up again today post the long weekend and I will be looking for that next trade. In light of this update, that trade could very well be one that benefits in a risk off environment. Stand by. 


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