Thursday, September 4, 2014

What international crisis will rile markets? It may not be what you think.

By Yesenia Duran

It has been a long hot summer of conflict as numerous geopolitical events have sprung up around the globe creating uncertainty with a threat of larger conflicts, which could upend markets and the fragile golobal recovery from the 2008 financial crisis.

Oddly these numerous hotspots has not translated into a spike in volatility but each is just one miscalculation away from an escalaition that could create a global market crisis.

Israel and Hamas have been invovled in a hot war in the Gaza strip while the Syrian civil war has spillled over into Iraq and a new radial Islamic group has emerged to threaten the region. Russia, not content with the annexation of the Crimea, has supported separatists in Ukraine threatening Western Europe and forcing it to choose between energy needs and the threat of old style Soviet expansion. Libya is still unstable as is much of North Africa.

With all this going on in the usual regions China and Japan--the second and third largest economies in the world--have their own conflict quietly brewing. 

While global conflicts often spark and then fizzle, with so much going on there is a chance one of these conflict escalates to an event that can have a dramatic effect on markets.

We thought this was a good time to ask our experts the following question: The world is awash in geopolitical risk. What countries/crises should you be watching (as a driver of price) and why?

Here's what they said.

Carl Larry

In oil we’ve come full circle as investors are coming back into the oil space. We’ve lost a lot of the big banks thanks to Dodd/Frank, but the fund money has been finding its way back. The difference is that instead of these macro funds coming in trying to learn how oil reacts to geopolitical risk, it’s now about the way that the oil markets react to macroeconomic events. Back in the 2000’s the risk was to the supply amidst geopolitical events, but now it’s about the risk of global economic risk and the effect on demand.

In the oil market the geopolitical events are getting less attention than a celebrity photo leak of the Golden Girls. What I do think is important to watch though is the effects of Russia will have on the EU. There has been a lot of hope bubbling up lately in the EU that as the U.S. refinery system heads into maintenance season (Sept-Nov) they might be able to pick up the slack and start making money again on imports here. Now if Russia tightens the natural gas supply to the EU, the higher costs for power generation are going to eat into any of those profit margins. Another stumbling block in the oil demand for everywhere but in the United States.

At the end of the day though, if the EU can’t make up any lost production of refined products in the US during this year’s maintenance, we’ll see oil prices here in the US get an unseasonal rally as our demand is going to outpace the loss in supply. 

Matt Weller

It feels as if there are an inordinate number of geopolitical events that are at risk of boiling over as we head into autumn. A fragile peace between Israel and Gaza, ongoing violence from ISIS in (Syria and Iraq) and the continuing conflict between Russia and Ukraine are the most salient risks for traders at the current moment, but the situation that could have the largest impact is China and Japan’s dispute over the Senkaku Islands.

For the uninitiated, the Senkaku Islands are an archipelago of uninhabited islands in the East China Sea that both Japan and China have laid claim to at various points over the last few centuries. Inhabitants of the two countries generally despise one another (a recent BBC poll showed that 73% of Japanese people view China negatively, while an incredible 90% of Chinese individuals view Japan negatively) and two governments’ dispute over the islands represents a matter of national pride.

Kara Boniecka

I take a somewhat contrarian view of geopolitics. Throughout history, there have been all manner of risks threatening global markets. This hasn’t and probably won’t ever change.  What does change is our awareness of these risks.  And that’s what makes predicting market movement on geopolitics so tricky. There are myriad ways in which our awareness of political situations can bubble to the surface. The timing of these catalysts is often difficult to predict.

What we can say is that when these factors do take hold of the collective imagination there are often three major impacts: i. a repricing of risk premia, which has investors demand higher returns on riskier assets, ii. an increasing risk aversion, which has them delay putting capital to work as they wait for “things to quiet down,” and iii. the discounting of deserved positive news as bleak portrayals of world conditions become accepted knowledge.  These have the net effect of increasing volatility and destabilizing momentum moves.  The good news is that this often brings fundamentals back into sharp focus.

So, what I watch for is not so much activity in a particular region or country, but rather threats that are imminent and not yet well-publicized. These are the ones that have potential to move markets substantially.

Dan Gramza 

Geopolitical risk and crises create uncertainty. Stock markets hate uncertainty and the commodity markets love uncertainty. Therefore, you expect stock markets to go down in reaction to fundamentals that create the anticipation of a future event or the specifics of particular action that has been taken.

Here is my take on a few key locatiions.

Although the euro area economic situation has calmed down, it has not completely recovered. My outlook is positive for this recovery to continue. A basic barometer to monitor are the 10-year interest rates for these countries. When a countries 10 year interest rate goes above 5%, the markets begin to be concerned. The concern increases dramatically when the 10 year rates increase above 6% and above 7% it is expected the country will need financial help. Current ECB actions have dampened market concerns about the economic stability of this region.

Ukraine/Russia: This conflict can dig deep into the health of European economies and can have long-lasting impact on international relationships.  All indications are that Putin has an agenda and is intent on implementing the agenda.

Iraq: Iraq was expected to provide 60% of OPEC growth for the rest of this decade. Iraq produced 3.3 million barrels per day of crude oil in May. Baiji is the largest Iraqi oilfield and it is located about 130 miles north of Baghdad and who will have control of this is in doubt. Approximately 75% of Iraq’s oil production is in the southern part of the country and so far has been uninterrupted. Remember, if there is an interruption of crude oil flow from Iraq or Libya, Saudi Arabia has excess capacity to cover the shortage.

John Caiazzo

I am concerned about a number of geopolitical situations: Gaza/Hamas Israeli conflict where the cease fire appears to be only to allow Hamas to regroup in my opinion. Also the continuing incursion into Ukraine by Russian military machine.

Matt Weller

China is the world’s second largest economy and Japan is the third largest, so if this situation escalates later this year, its trading impact could dwarf the impact of any of the above conflicts. While everyone else is focusing on the geopolitical minnows right now, astute traders will be watching to see whether the geopolitical whale of a risk between China and Japan will rear its head later this year.

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