There’s quite a bit of talk these days about what’s “priced in” and what’s not.
The market, for instance, had “priced in” an expansion (not just an extension) of PSPP and a 20bps cut from Mario Draghi this week and as it turns out, the market was wrong, leading the likes of Goldman to go the mea culpa route (“we badly misread this meeting”).
But while everyone is keen on trading the rumor and trying to get out ahead of central bankers, no one seems interested in pricing in the myriad geopolitical risk factors that loom large on the horizon going into 2016.
Perhaps the market feels as though when it comes to capital markets, nothing short of a nuclear holocaust will be sufficient to trump central bankers hell bent on keeping the party going. Or perhaps investors simply don’t understand the gravity of the innumerable risk factors at play, but whatever the case, savvy market participants keen on “getting it right”, so to speak, might be wise to start pricing in some risk other than that which stems from the possibility that a central planner might not lean quite as dovish as everyone wants them to at the next policy meeting.
To be sure, the implications of pricing in geopolitical risk need not necessarily lead one to a bearish conclusion. A war time boost might be just what the US economy needs to finally get back to trend (lord knows the MIC would love it) from a growth perspective, and one has to think that no matter how long OPEC keeps flooding the market, crude might well spike in the event NATO decides to shoot down another Russian plane in Syria or vice versa.
And we cannot forget about epochal political shifts in key emerging economies (e.g. Brazil, Turkey, and Malaysia), EU periphery hot spots (e.g. Spain and Portugal), and in America (where anti-establishment candidates are capitalizing on voters’ disgust for politics as usual inside the Beltway).
Of course the Janet Yellens, Mario Draghis, and Haruhiko Kurodas of the world will likely still dominate when it comes to explaining why markets behave the way they do on a daily basis, but recognizing the importance of analyzing geopolitics in the course of evaluating the outlook for markets is nonetheless critical.
Recognizing this, Citi is out with some new commentary that’s worth a read for those who understand that there’s more to developing a prudent, long-term view of where asset prices are heading than parsing what a PhD economist mutters at a press conference - or at least there should be.
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In our view, investors should be prepared for the convergence of rising “Old” geopolitical risks with “New” socio-economic risks, creating more destabilizing byproducts in the process. Such outcomes are already in evidence with the burgeoning refugee crisis and the spike in terrorist activity, symptoms of profound foreign policy failures and shortcomings in global governance in controlling their escalation. Together, these rising risks may form a toxic brew that exceeds the capacity of central bank liquidity to mask them.
In the year ahead, geopolitical risks likely pose the greatest potential to disrupt markets in terms of event risk. But failure to address new socio-economic risks, such as income inequality and youth unemployment, runs the arguably much greater risk of undermining the functioning of the global system, creating a negative feedback loop. There is also the potential for geopolitical risks to intersect with economic fragility in the event of a downturn, amplifying both.
The November terrorist attacks in Paris took place in a year that saw a significant uptick in the nature and the extent of the risk of terrorism, mainly at the hands of ISIS. In our view, the Paris attacks mark a turning point with global implications. In a tactical sense, the attacks marked a new stage in ISIS approach, being a series of coordinated attacks, perhaps centrally-planned, and, crucially, outside of ISIS’s field of operations (the self-proclaimed “Caliphate”) where it has sought to establish its parallel state and expand its territorial reach. It remains to be seen whether the group has the capacity to launch other attacks in developed market capital cities.
Terrorism is not a new risk, but overall, levels of violent conflict are at a post-Cold War high according to the Uppsala Conflict Data Program, which tracks three types: armed conflicts between states, between non-state groups, and civilian massacres. 36 ISIS’ shift away from the symbolic soft targets of Al Qaeda’s “spectaculars” to mass shooting incidents in capital cities, focusing on fairly undistinguished targets, will be difficult to combat. With the flow of foreign fighters to and from Syria continuing, the desire to maintain open borders has never seemed under greater threat in the post-Cold War era.
For 2016, Fewer Systemically-Significant Elections: US, Taiwan and Brexit Referendum in Focus
There are — perhaps mercifully — relatively few systemically-significant political signposts with the potential to influence global markets in 2016. The most impactful include US presidential elections in November and the UK referendum on EU membership (due by end-2017). Taiwanese general elections and South Korean parliamentary elections will also take place, with Taiwan especially closely-watched given the country’s relationship to China. Other government collapses and/or snap elections may also emerge of course where governments fall under pressure, with Venezuela bearing close watching.
Instead of the usual focus on election-watching, it may be that the political significance of 2016 will not be about election results this year, but in how economic and political conditions will influence the coming constellation of systemically significant elections in France and Germany in 2017 and the context for scheduled leadership transitions in China and Russia (see Figure 57)
US Elections — Anti-Establishment Republican Candidates in the Lead, But For How Long? Will the US Have its First Female President? Anti-establishment candidates Donald Trump and Ben Carson continue to dominate polls for the Republican nomination, with sustained popularity for surprise Democratic challenger Bernie Sanders, a self-declared Socialist in a country where the term is typically regarded as a political insult. Candidate after candidate has made blunders that would, under other circumstances, have cost them US public support. This time, Americans seem to be rewarding candidates who depart from the usual political script. With just under a year to go, the US political establishment and markets have not been overly concerned, with most treating the race as rather colorful political theatre, but we suspect that will soon change.
Could the UK Vote to Leave the EU? Rising Brexit — and UK Breakup — Risk Could the UK vote to leave the European Union? Once no more than a tail risk, in our view Brexit risk is on the rise, with perhaps a 20-30% probability. The pro-EU lead has fallen in recent months to roughly 3 percentage points. Could Brexit really happen? It is far from impossible — we consider Brexit risk to be one of the top global political risks; if it transpires, it would likely prompt a wider unravelling within Europe.
The Refugee Crisis and EU Political Risk: Welcome Refugees, Goodbye Merkel? European policymakers are struggling to resolve the refugee and migration crisis, which follows in the wake of a list of challenges, from the Greek debt crisis, the Russia-Ukraine conflict and the broader challenge of reforming the Eurozone and EU architecture, and is emerging as a significant source of political risk. In addition to influencing election outcomes, the refugee crisis will test cohesion between EU member states, requiring burden-sharing on a topic much more unpopular with their voters than bailouts: immigration. The potential for the refugee and migration crisis to destabilize the EU could eventually overshadow Grexit (in any case a lower risk for 2016 than in previous years). Could it also be the undoing of the European politician who has done the most to help resolve it?
Geopolitical Outlook: The Syria Conflict Enters its Fifth Year, and What Will Follow the End of Sanctions in Iran? As the Syria conflict enters its fifth year, Europe’s political imperative to stem the flow of refugees and Russia’s expanded military intervention in Syria are altering the regional political calculus, forcing Washington’s hand as the US enters an election year. The Obama Administration’s recent decision to send approximately 50 “special advisors” highlights the degree to which the security situation in Afghanistan, Iraq and now Syria have all worsened, compelling President Obama, who came to power promising to extricate US forces from these conflicts, to revisit the US stance. What will be the impact of these moves: will the conflict expand, or could the refugee crisis and Paris attacks provide the impetus for cooperation that will pull the Syria conflict out of its downward spiral — and potentially lead to a rapprochement between Russia and the West? Although diplomatic differences have narrowed encouragingly, it is difficult to envision a durable political solution emerging soon. The recent Turkish-Russia military incident underscores the risk of so many actors, with often competing interests, operating in an increasingly crowded military theatre.
A key regional wildcard will be impact of the end of (much of) the sanctions regime against Iran, a rare recent example of a diplomatic breakthrough, and one fraught with controversy. Can the Iran deal withstand rigorous inspections, opposition from Iranian hardliners, and the potential for regime change in Washington? How will Tehran exert influence in the region, and how will other regional players, from Riyadh to Jerusalem, interact with it?