Goldman On The Consequences Of Recent Geopolitical Events

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The current US air strikes in Iraq are unlikely to have a significant impact on defense spending or oil prices, Goldman Sachs writes, unless the scale of the conflict changes considerably. Evidence from past US conflicts that were similar in scale also suggests little impact on confidence and at most mixed evidence of a flight-to-safety effect in financial markets. The exchange of sanctions with Russia - a relatively minor US trading partner - is also likely to have only a modest impact on the US economy. Of course, Goldman caveats, both situations are highly unpredictable; as they expect little reaction to recent events from Fed officials, who have generally not discussed conflicts of this magnitude unless accompanied by other economic concerns, such as a large rise in oil prices.

Via Goldman Sachs,

In today's note, we answer a number of frequent questions about recent geopolitical developments, in particular the recent air strikes in Iraq and the latest rounds of sanctions between the US and Russia.

Q: How are the current air strikes in Iraq likely to affect defense spending?

A: On August 7, President Obama announced that he had had ordered the US military to conduct air strikes in Iraq against forces of the Islamic State (ISIS) and to distribute aid to refugees from the fighting, but said that he "will not allow the United States to be dragged into another war in Iraq" (New York Times). As currently planned, the action would be most similar to previous small-scale air operations, such as a 1998 action in Iraq or the 2011 conflict in Libya, in which costs have run from the hundreds of million to about $1bn, as shown in Exhibit 1. Relative to monthly Department of Defense outlays in excess of $40bn, such costs would not noticeably change the defense spending picture. In terms of timing, national accounts data on sub-categories of defense spending (in particular missiles) surrounding eleven previous conflicts of this magnitude (shown below in Exhibit 3) suggest that the impact is likely to appear in the initial or following quarter, if it is observable at all.

Military actions can of course be highly unpredictable, and past experience suggests that spending risks are slanted to the upside: as economist William Nordhaus has noted, the costs of past US conflicts were frequently underestimated in advance. Previous medium-scale conflicts, such as those in Bosnia and Kosovo, have seen costs in the $5-$10bn range, while larger wars--shown on the right-hand side of Exhibit 1--have seen dramatically higher costs. As a baseline, however, we do not expect the current air strikes to disrupt the recent downward trend in defense spending. Defense spending has fallen by about one-sixth since 2010Q3 in real terms, shrinking from 5.6% of GDP to 4.4% in 2014Q2.

Q: How large of an impact is the conflict likely to have on oil prices?

A: Oil prices rose to a nine-month high in the days of conflict over the Baiji oil refinery, Iraq's largest. But the increase reversed in the following week without a clear reversal of the situation in Baiji, and most major developments in the conflict with ISIS have not been associated with large daily changes in oil prices, as shown in Exhibit 2. In contrast, larger previous conflicts in Iraq and elsewhere in the Middle East saw much larger swings in oil prices, often with large macroeconomic consequences. One reason for the limited reaction recently is that despite its advances in northern and western Iraq, ISIS remains far from the key southern oil fields and export terminals. A second reason is that shale has reduced the vulnerability of oil markets to supply shocks originating in the Middle East.

Q: Are other economic or market impacts likely?

A: The modest impact on defense spending suggests that to be economically important, small-scale conflicts would need to affect either confidence or financial conditions. To gauge the likely impact of the current conflict, we look back at eleven earlier US conflicts of similar magnitude. We find no obvious effect on measures of confidence following the start of US involvement, and only mixed evidence of a flight-to-safety effect in market data (Exhibit 3). One obvious limitation of this analysis is that, in contrast to recent events, most of the other events were not particularly surprising by the time US involvement began.

Q: How will recent sanctions affect US trade with Russia?

A: While early rounds of US sanctions targeted Russian individuals and associated companies, new sanctions imposed in July were more severe. The US and EU have imposed sanctions on firms in the financial, energy, arms, and shipping industries, and Russia has responded with import restrictions on agricultural products.

While sanctions are likely to have a larger impact on the Russian economy, the effect on the Euro area economy is likely to be more modest and the effect on the U.S. economy is likely to be smaller still. Russia is a relatively minor US trading partner, accounting for an average of just 1.1% of US goods imports and 0.7% of US goods exports over the last 12 months, of which about $1bn was US food exports (compared to total US exports of over $2 trillion). That said, Russia accounts for a considerably larger share of US trade than most other recent US sanctions targets, and some multi-nationals have already noted a hit to sales.

Q: Will Fed officials seek to counteract geopolitical risks?

A: Last week, European Central Bank President Mario Draghi noted that "geopolitical risks are heightened" (ECB press conference) and said that recent developments potentially pose risks to both growth and price developments in coming quarters. How likely are Fed officials to express similar concerns or act in response to these risks?

In the FOMC meetings immediately following the outbreak of the eleven conflicts shown in Exhibit 3, we find only two occasions on which the minutes, transcripts, or statements referenced the conflict. Following the start of US involvement in the Kosovo conflict, Governor Edward Kelley pointed to the possibility of "a very nasty war in the Balkans" as a reason for the Fed not to hike preemptively, and Chairman Alan Greenspan agreed (transcript). More recently, Chairman Ben Bernanke cited the conflict in Libya as a cause of higher energy prices in his press conference, and the FOMC statement at the time highlighted "concerns about global supplies of crude oil." This suggests that current geopolitical risks are likely to influence monetary policy only if associated with a sustained spike in energy prices. The Fed's Monetary Policy Report issued on July 15 noted that oil prices had risen beyond their recent range "only temporarily in reaction to events in Iraq," and prices have since declined.

The limited response to smaller conflicts reflects their modest economic and financial impact, as well as the concern--noted in 1998 by former Cleveland Fed President Jerry Jordan--that while the Fed has "a long history of responding to … international events such as financial crises and military actions," it has to "be very, very careful about how much of a response we make because the developments in question tend to be reversed. … We have had a number of episodes in the past where we responded to surprises and overstayed our response"

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So summing it all up - don't sweat it... geopolitics, schmeopolitics... (unless of course things escalate)