The following post was kindly provided by IG
Those paying attention to world news in recent weeks could be forgiven for thinking that we were almost returning to a cold war period, as tensions between Russia and the west escalate amongst increasing human tragedy.
Geopolitical risk has been dominating the headlines in a way not seen since the beginnings of the Arab Spring as conflicts in Ukraine, Iraq, Gaza and Syria show little sign of abating. Gaza and Ukraine in particular have distilled into global politics, as interested parties increase their involvement.
Under such tense conditions, it may come as a surprise and a contradiction to common sense that last week we saw stock indices reach new highs with the US S&P 500 touching a new intra-day record. Markets appear to have priced in the chance of an escalation and economic sanctions as a near zero-possibility.
Is this a significant overlook or a fair assessment of the current geo-political situation and health of the financial markets?
When news of the MH17 crash emerged, safe haven assets initially rallied and indices dropped. However, both the prices of gold and indices have since returned to pre-crash levels.
No panic, no market crash, no volatility.
10 years ago, an event of this magnitude would have caused worldwide tremors. There are a number of hypotheses as to why markets are not reacting to the rise in geo-political tensions and events of this sort.
One obvious reason is that since the 2007 financial crisis, central banks have embarked on an ultra-aggressive, ultra-loose monetary policy known as quantitative easing. With substantial amounts of cash being injected into the economy, the previous unpredictability of investor cash flows has been significantly reduced and the result is that volatility has been ironed out, ultimately artificially supressed.
Indeed, this year we have seen some of the lowest volatility in years. Foreign exchange and equity volatility have come close to 25 year lows and it has to be said that for risk-takers and traders alike, financial markets have generally been rather dull. The result is that traders are finding themselves taking on significantly higher leveraged positions in an attempt to render similar returns on capital.
Another reason we have seen a decline in volatility is that since the financial crisis, systematic risk has been significantly reduced. New laws have been put in place, like the Dodd Frank act, that provide financial reform and offer increased transparency into Wall Street operations. Banks have to hold substantially more capital than before, balance sheets are overall healthier and less leveraged. One could argue that the financial markets have never been more robust and are in a much better place to deal with a market crash than ever before, reducing risk and ultimately reducing volatility.
Another element that could explain the low volatility and little reaction to the current geo-political tensions is that we find ourselves in the recovery stage of the economic cycle where volatility is historically low. The flow of economic data has been increasingly positive over the last few years with no hints of an economic slow-down or reversal of the current cycle we find ourselves in. GDP figures released Thursday last week showed global growth was up 3.3% between the fourth quarter of last year and the end of 2014, some of the best figures witnessed over the last decade.
Finally, and possibly more problematic in the long term, is the possibility that traders and investors have become too comfortable and over-confident in forecasting market movements and politics.
Indeed market participants seem to have speculated that any real economic sanction for Russia is off the table quite simply because purposefully damaging Russia’s economy invariably means purposefully damaging the European and US economic recovery.
It’s more than likely that a combination of the four points mentioned above are all playing a strong contributing factor to the markets dismissal of geo-political tensions.
So whilst geo-political tensions may be escalating, it appears that low volatility may be here to stay for quite some time, setting a new norm. Until European leaders are prepared to take a bold stance on unruly neighbourly behaviour and until central banks reduce their loose monetary policies or until the trend of positive economic data takes a turn, the bull, low-volatility market appears here to stay.
When it comes to increased volatility, it is more than likely going to be a combination of factors that will trigger such a change. No one knows when volatility will return but when it does, the bears will be out of hibernation and will be very hungry. Be prepared to run if you don’t want to be eaten alive.
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