Members of the Iranian military march during an Army Day parade in Tehran on April 17. During the parade, President Ebrahim Raisi said the “tiniest invasion” by Israel would bring a “massive and harsh” response, as the region braces for further escalation. Photo: AP
Opinion
Macroscope
by Nicholas Spiro
Macroscope
by Nicholas Spiro
With Mideast on brink, investors ignore geopolitical risks at their peril
If investors are indeed concerned about geopolitics, their fears are not reflected in the market as equity investments remain at all-time highs
An escalation between Iran and Israel would disadvantage emerging market currencies, fan inflation and widen the gap between asset prices and the real economy
Investors are often accused of being complacent about vulnerabilities in the global economy, particularly geopolitical risks which have not been this acute in decades. Yet this is only partly true. A cursory glance at surveys of market sentiment suggests investors are increasingly concerned about the dramatic escalation in geopolitical tensions in recent years.
Since the beginning of this year, respondents to Bank of America’s global fund manager survey have cited geopolitics as one of the most important “tail risks” in markets along with higher-than-expected inflation. Indeed, over the past decade, geopolitical risks have figured prominently among the biggest concerns of investors, according to the survey’s findings.
Yet, traders have a tendency to say one thing and do another. As JPMorgan noted in a report on Monday, “equities remain significantly higher [year to date] and continue to hover around all-time highs, while credit spreads are trading at or near post-[2008 financial crisis lows]”.
If investors are worried about geopolitics, their fears are not reflected in asset prices. Moreover, the parts of the markets that are under strain, such as US Treasury bonds and emerging market currencies, are suffering not because of geopolitical risks but because of investors’ belated realisation that the US Federal Reserve will struggle to cut interest rates this year.
Markets are notoriously poor at assessing and pricing geopolitical risks, especially low-probability, high-impact events such as wars. Discounting these type of threats is often the right thing to do. Unlike financial risks, all-out military conflicts are binary: either the status quo endures or things take a dramatic turn for the worse, in which case every asset is at risk.
Yet taking the view that the most severe geopolitical risks are the ones that should be ignored or downplayed is misguided. At a time when the global economy is weak and vulnerable, stock markets – especially in the US – are priced for perfection and the world’s most influential central bank is signalling that it will keep borrowing costs higher for longer, geopolitical risks matter more than ever.
Emergency service personnel work among the rubble of Iran’s consulate after it was hit by an Israeli air strike, in Damascus, Syria, on April 1. Photo: AP
Iran’s decision to launch a barrage of armed drones and missiles at Israel on April 13 – the first ever direct Iranian attack on the Jewish state – in retaliation for an Israeli air strike on Iran’s consulate in Syria puts the Middle East on the brink of a full-scale regional war. Fordham Global Foresight says the attack represents “the biggest uptick in Middle East geopolitical risk [in 30 years]”.
Even if one takes into account that the US has become a net exporter of energy and is therefore less sensitive to a spike in oil prices than it was in the 1970s, a hugely consequential geopolitical Rubicon has been crossed. Any major reprisal from Israel, especially an attack on Iran itself, would probably prompt further retaliatory action from Tehran and set off a cycle of escalation.
Such an outcome would have catastrophic consequences for the Middle East and the rest of the world. The concentration of geopolitical risk in the Strait of Hormuz – the vital energy chokepoint at the mouth of the Persian Gulf which Iran can use as strategic leverage in its stand-off with the West – raises the stakes for the global economy and markets. It was not for nothing that former US secretary of state Cyrus Vance called the chokepoint “the jugular vein of the West”.
Moreover, geopolitics is not just about energy markets. The major escalation in hostilities between Iran and Israel could not come at a worse time for global security. The West’s apparent willingness to let Ukraine lose its war with Russia poses a huge threat to Western interests and values. Moscow is already benefiting from the recent rise in oil prices due to its success in circumventing Western sanctions. An Israel-Iran war-induced oil supply shock would be a boon for Russia.
This is why the relatively muted reaction in markets to the heightened risk of a full-blown regional conflict in the Middle East smacks of complacency. Although global stocks have come under pressure, the benchmark S&P 500 index is only 4.4 per cent below its latest all-time high set on March 28. Brent crude, the international oil benchmark, which has risen since early February, has even fallen since Iran launched its attack.
While betting on geopolitics is a fool’s errand, there is no reason markets should be so unconcerned. The threat of an outright war between Israel and Iran, which could drag in the US, amplifies other vulnerabilities in the global economy.
First, it undermines confidence among businesses and fuels concerns about a renewed slowdown, especially in Europe which has been flirting with recession for the past year.
Second, geopolitical instability underpins the rally in the US dollar due to its status as a safe haven. This contributed to sharp sell-offs in emerging market currencies, particularly in Asia. Third, mounting geopolitical tensions risk fanning inflation, making it even harder for the Fed to begin an easing policy.
Lastly, and perhaps most importantly, instability accentuates and exacerbates a dangerously wide gap between asset prices and the real economy at a time when the world faces more dangers than most traders have ever witnessed in their lifetimes.
It is hard enough for investors to predict when the Fed is going to cut interest rates, never mind anticipating Israel’s response to Iran’s attack. Yet turning a blind eye to geopolitical risk is not the answer. Markets are far too complacent.
