The limited impacts of geopolitics: Patrick Artus's Argument
Patrick Artus, chief economist at Natixis, argues that high geopolitical risks are likely to foster economic impacts - as a rise in commodity prices - and financial effects -such as increased volatility and risk aversion. These impacts can represent a significant threat to growth. Nonetheless, he shows that today’s geopolitical risks have limited effects on the economy: there is no rise in the gold or oil prices, no decline in emerging stock market indices, no rise in sovereign risk premia for the peripheral Eurozone countries. Moreover, geopolitics’ impacts are limited on the financial market as there is an abundance of liquidity on the market that has excluded economic and geopolitical risk premia.
Why are the usual effects of geopolitical risk not occuring?
Patrick Artus 11 August 2014
We are currently in a period with high levels of geopolitical risk on a global scale, particularly in areas such as Syria, Libya, Iraq, Nigeria and Venezuela or from the tensions between Ukraine and Russia, China and Japan or Israel and Palestine. Increased risk usually brings several predictable consequences – consequences that have been notably absent in this recent period of geopolitical risk. By distinguishing the expected effects of risk, and identifying to what extent they have occurred recently, we can examine the current impact of geopolitical risk on the financial markets.
The expected impact of geopolitical risk
The economic effects of high risk typically include a rise in volatility – measured by indicators such as the VIX (Chicago Board Options Exchange Market Volatility Index) and Natixis’ own risk perception index. Periods of high risk also typically result in a rise in commodity prices – especially if it occurs in oil-producing countries, as is currently the case in Libya, Iraq, Venezuela, Nigeria and Russia.
Furthermore, during times of high risk investors tend to switch to ‘safe’ investments – such as risk-free government bonds and precious metals – and ‘safe’ currencies such as the USD or JPY. In addition, the prices of riskier assets – including corporate, household and bank debt; sovereign bonds from peripheral Eurozone countries such as PIIGS; equities; and assets, sovereign bonds and currencies from emerging countries – usually experience a significant drop.
The typical impact of geopolitical risk on financial markets, in terms of increased risk aversion, is similar to that caused by other types of risk. Aside from a rise in commodity prices, the above factors (a rise in volatility, a drop in risky asset prices and a switch to safe investments and currencies) were all evident during the Lehman crisis of 2009 and again during the euro crisis in the winter of 2011/2012. The reason commodity prices did not rise, as they would have in other crises, is because the above two periods were characterised by high financial risk, which, unlike geopolitical, banking or sovereign risk, leads instead to a fall in commodity prices due to expectations of a decline in activity.
Regardless, such consequences are always a cause for concern because factors such as rising commodity prices, rising funding costs for households and companies, and rising risk aversion can present a significant threat to growth.
Overall, periods of high risk (such as 2009 and the winter of 2011/2012) generally result in:
A fall in long-term interest rates on risk-free bonds;
A fall in stock market prices;
A fall in emerging-country equities;
A rise in the price of gold and oil;
A rise in the dollar and the yen and a fall in the euro;
A depreciation of emerging currencies;
An increase in risk premia on all “risky” bonds;
An increase in emerging countries’ Credit Default Swaps (CDS);
A rise in volatility.
Such effects are transferred to the economy via direct and predictable mechanisms; for example a rise in commodity prices leads to a decline in supply and demand for goods and services, or an increase in risk premia on risky bonds sparks a decline in corporate and housing investment.
The real impact of current geopolitical risks
Despite the usual prevalence of these factors, the recent period of increasing geopolitical risk has been characterised by:
A continued fall in long-term interest rates on risk-free bonds – although this is in-keeping with the preceding trend;
No decline in emerging stock market indices;
A modest decline in share prices, and only for European equities;
No rise in the gold or oil price;
A slight widening of credit spreads;
No rise in interest rates on household loans;
A slight depreciation of the euro against the dollar;
No depreciation of emerging currencies;
No rise in sovereign risk premia for the peripheral eurozone countries – except for Portugal where it is likely due to the collapse of the Portuguese bank Espirito Santo;
A slight rise in bank CDS in the eurozone, which can also be largely attributed to the problems surrounding Espirito Santo;
No rise in the CDS of emerging countries;
A very brief rise in the VIX followed by a decline.
Given these minimal responses, it is apparent that the impact of current geopolitical crises is very limited.
Why has there not been a greater impact?
At the moment, several oil-producing countries present high geo-political risk, including Libya, Iraq, Nigeria, Venezuela and Russia. The situation between Israel and Palestine is clearly sensitive and the extent of ongoing and future sanctions against Russia – and potential negative consequences for the EU economy – is not yet known. Although exports to Russia account for less than 1% of EU GDP, further sanctions could result in a loss of business for banks and oil companies.
However, the current severe and widespread geopolitical risks are barely affecting the financial markets. There are two potential causes for this. Firstly, it is possible that the risks are perceived by investors to be less acute, or ‘investor cynicism’ has insulated against them because the crises are not affecting main economies such as the United States, China or Japan. Secondly, it is also possible that the current abundance of liquidity, which has already eliminated economic risk premia, is also eliminating geopolitical risk premia. We have witnessed how plentiful liquidity can lead investors to ignore economic risks such as prolonged poor growth in the eurozone, the downturn in Japan and the weakness of several large emerging countries’ economies; perhaps it is now causing them to ignore geopolitical risks.
