Political risk evident everywhere except the markets
London, July 3, 2014
By John Kemp
"Geopolitical risk" turns out to have surprisingly little impact on the valuation of oil and most financial assets.
Since the beginning of 2011, revolutions and counter-revolutions have rocked the Arab world, sanctions have slashed oil exports from Iran, and unrest has cut production in South Sudan and Nigeria, and none of these events has had any significant impact on oil prices.
The world's most important oil exporting region has descended into chaos, with armed conflict within just a few miles of some of the world's largest oil fields, yet the day to day change in benchmark prices has been the smallest at any time for more than 20 years.
None of the daily price changes so far in 2014 has reached 2 standard deviations let alone 3 or 4. Volatility in futures prices is near to the lowest it has ever been.
Calm is not confined to oil. Most other commodity markets, like gold, and higher-risk asset classes like equities and emerging market bonds exhibit the same tranquility.
In other regions, civil war has broken out in Ukraine, China is locked in acrimonious maritime disputes with its neighbours, the Communist Party is in the midst of the biggest purge since the 1970s, Britain's relations with the European Union are becoming increasingly strained, and Argentina is flirting with default.
But none of these political risks is evident in the financial markets.
Entire forests have been felled as investment analysts and financial journalists attempt to explain the "death of volatility".
Top-down explanations focus on the role of the major central banks in supplying liquidity, pumping up the value of riskier assets, and effectively guaranteeing investors against bad outcomes.
Bottom-up analyses focus on all the other factors which have helped offset rising political risks at a micro level.
In the oil market, for example, production losses from Sudan, Libya, Nigeria, Syria and Iran have been almost exactly offset by increased output from shale formations in North America.
Rebels from the Islamic State in Syria and the Levant remain some miles from the main oil-producing areas in Kurdistan and southern Iraq.
Actual production losses so far remain small and Saudi Arabia has promised to hike production to meet any shortfall in supply.
It is possible to rationalise the absence of volatility in oil, commodities and other financial markets by combining some of these explanations.
But it remains unconvincing. Most of the explanations are based on long-term structural factors and should have been built into prices long ago.
Markets are supposed to respond to new information. Some sort of reaction to the news flow - much of which has been dominated by international politics, and most of which has been negative - should be evident in valuations.
In fact, geopolitical risk is arguably less important for the pricing of oil, other commodities and financial assets than most analysts and journalists assume.
Like many other professional analysts, my degree had a large component of politics and international relations, and I find the subject fascinating.
It is therefore tempting to assume politics and international relations have a major impact on asset prices simply because they dominate the headlines, are familiar to writers, and are "big" events which should have big consequences (displaying all the behavioural biases familiar to economists and psychologists).
But that overstates the role of geopolitical factors in financial markets. In fact many of the biggest international incidents of the modern era, including the attack on Pearl Harbour, the Cuban Missile Crisis and the fall of the Berlin Wall, had no discernible impact on markets.
Many big market movements, such as the stock market crashes in 1929 and 1987, and the flash crashes in 2011 and 2012, had no apparent political or economic trigger.
Iraq's invasion of Kuwait sent oil prices surging in 1990, but by less than the spike in 2004-2008, which had nothing to do with politics.
None of this is meant to imply that geopolitics and international relations have no impact on commodity and asset prices.
There have been clear instances to the contrary, such as the stock market crash which followed the attacks on the World Trade Centre in New York in September 2001.
But geopolitics is only one of many factors which influence financial markets and in most cases not the most important.
Engineering, business, social and economic developments are usually more influential, if not always so obviously headline grabbing.
History suggests geopolitical factors sometimes but not always have an impact on perceptions about risk and asset values.
The more remote the risk the less impact it has on valuations, partly because remote risks are likely to be less important, and partly because their ultimate impact is much harder to assess, and investors prefer to focus on risks that are more easily quantifiable (those behavioural biases again).
If the foregoing analysis is true, it is not possible to trade oil or other financial assets based purely or mainly on a geopolitical view (which may explain why banks spend so little time and money on international political research).
Investors who try to trade the market based on a geopolitical view will probably, on average, lose money because they overestimate the effect international relations has on asset values in the short term. In fact the "smart money" is probably trading against them.-Reuters
(John Kemp is a Reuters market analyst. The views expressed are his own.)