Geopolitical Risk for the Market?

by Laura Ehrenberg-Chesler on March 22, 2013

in equity market,Geopolitical,politics

While we make a point to avoid investing around the “unknowable”, like geopolitical risks that are a low probability, we don’t think they should be completely ignored either.

In a research piece from Ed Yardeni on March 14th, this topic is discussed in a thought provoking way.

The dearth of growling bears and the lack of volatility may be the calm before the storm. Again, I don’t think so, but let’s stay alert. You might recall that earlier this year on January 29, I wrote, “We Have Nothing to Fear but Nothing to Fear.” Of course, if we are looking for trouble, it isn’t hard to find lots of worrisome headlines about all sorts of “event risks.” Right now, they mostly tend to be geopolitical in nature. Consider the following:

 (1) Iran. The Middle East is always good for a scare, though it is getting scarier as Iran is moving faster to build nuclear bombs and missiles to deliver them. Press reports have appeared recently about how North Korea is helping Iran achieve these goals.

 (2) North Korea. Meanwhile, North Korea’s young new leader seems to be playing with fire by threatening to attack South Korea and even the United States.

 (3) China. It’s puzzling that the Chinese haven’t reined in their bellicose neighbor. Maybe they’ve been too busy with their cyber war against the United States. China’s new leader seems to be siding with his generals who dream of a Chinese military mightier than America’s.

 It’s unnerving seeing the rise of militarism in Asia at the same time as America seems intent on spending less on defense. Could the former development be related to the latter one? I think so.

 My observation is that geopolitical event risks are rarely discounted by the market. When such a risk turns into a reality, whether anticipated or totally by surprise, it often turns out to be a brief buying opportunity right after the initial shock causes stock prices to tumble. However, if such events–typically a heated exchange of words and even a few shots across a border–are followed by a cease fire and negotiations that avoid a violent spiraling into a major prolonged conflict, then the market quickly recovers. Admittedly, this is a very stylized version of lots of very different historical shocks, omitting a few that did spiral out of control, e.g., the assassination of Archduke Franz Ferdinand on June 28, 1914 and the bombing of Pearl Harbor on December 7, 1941.

Interesting to ponder as the markets continue their march to new highs.

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