Two years ago, investors suddenly became amateur epidemiologists in an effort to determine the level of economic disruption wrought by the Covid-19 pandemic. At the time, virologists themselves were deeply uncertain about the evolution of the virus, while testing capacity was too limited for sweeping conclusions to be drawn.
Yet, almost overnight, investment banks began producing reams of research on the pathogen, some of it highly technical, involving assessments of reproduction numbers and predictions of turning points in countries’ infection curves.
Today, markets no longer worry about the pandemic, mostly because of the deployment of vaccines. Instead, traders have reprised their roles as amateur defence and security analysts, frantically trying to assess the likelihood of a Russian invasion of Ukraine and its consequences for the global economy and markets, especially energy prices.
The stakes are much higher now. Leading central banks are starting to withdraw stimulus, making investors more sensitive to risks in the global economy. In a world that has moved rapidly from a low inflation environment to one of spiralling prices, the actions of Russia – the world’s largest exporter of natural gas and the second-largest exporter of oil – and the West’s response have major implications for the outlook for inflation.
More worryingly, a collapse of security in eastern Europe could have far-reaching consequences for the other main geopolitical flashpoint: the escalation in tensions in the Taiwan Strait.
While there are crucial differences between the two cases, they give impetus to a realignment in geopolitics as Russia and China challenge the underpinnings of a vulnerable US-led liberal world order.
However, investors have enough problems gauging economic and financial threats without having to speculate about answers to questions that military analysts and international relations experts are better qualified to address.
Geopolitical risks, while an increasingly important determinant of sentiment in the past several years, have long been dangers that markets downplay due to a combination of complacency and the difficulty in quantifying risks that are unquantifiable.
In Bank of America’s latest global fund manager survey, published on Tuesday, the Russia-Ukraine stand-off barely made it into the top five risks to markets.
This has less to do with the likelihood of a de-escalation of the crisis – divining Russian president Vladimir Putin’s intentions is hard enough for veteran Kremlin watchers, never mind ill-informed traders – and more to do with an innate reluctance on the part of investors to take nightmare scenarios, especially wars, seriously.
In a sign of how years of ultra-cheap money have conditioned investors to care only about the degree to which geopolitical risks affect monetary policy, JPMorgan, in a report published on Wednesday, said that even though “the risk of conflict in Ukraine is high, it should have limited impact on global equity markets and would likely prompt a dovish reassessment by [central banks]”.
A full-blown Russian invasion of Ukraine would heap more pressure on policymakers, given that the crisis has already helped drive oil prices to an eight-year high, fuelling inflation and providing a foretaste of the price shock in the event of an all-out war. And the tensions themselves have accentuated long-standing weaknesses in the Western alliance and revealed the acute challenges in presenting a united front, particularly on sanctions.
Disagreements over the fate of the Nord Stream 2 gas pipeline linking Russia and Germany have strained relations between Washington and Berlin for years, and show how hard it is for Europe to face down Russia, its leading source of natural gas.
Yet, these divisions pale in comparison to the ones that would arise in the event of a major conflict over Taiwan, given China’s much bigger role in the global economy and markets. There are already concerns about financial stability if Russia is cut off from the Swift international payments system. Crippling economic and financial sanctions on China would trigger a 2008-style crash, one that does not bear thinking about.
This is partly why investors see little point in pricing potential geopolitical disasters. However, they cannot ignore them, especially when the comfort blanket of super-loose monetary policy is being taken away and there are mounting concerns about a sharp policy-induced slowdown.
Indeed, one of the areas where the interests of Moscow and Beijing converge is in exploiting political and economic weaknesses in the West. The crisis in Ukraine has contributed to the dramatic surge in volatility in US markets this year, making it harder for the Fed to start raising interest rates. It also makes it more difficult for US President Joe Biden’s administration to focus on China, its top foreign policy priority.
Geopolitical risks are too difficult, and often too terrifying, for investors to assess and price accurately. Yet, just because worst-case scenarios are very unlikely to materialise does not mean the risks themselves cannot inflict financial and economic damage, particularly as the era of cheap money comes to an end.
