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Geopolitical Shocks and Financial Markets

Summary:
Involuntary Early Retirement of a Middle Eastern General The procession of news through the week – namely that chronicling the aftermath of the targeted drone strike and killing of Iranian General Qasem Soleimani – advanced with an agreeable flow.  The reports at the start of the week were that Orange Man Bad had spun up a Middle Eastern mob of whirling dervishes beyond recall. World War III was imminent. The recently expired general, when he was still among the quick – and seemingly in a good mood.  [PT] Photo via harpy.ir But after Iran’s token missile launch on Tuesday, with no American causalities, President Trump Tweeted: “All is well!”  Then, on Wednesday, major U.S. stock indices gave the “all clear” signal.  By Thursday, the

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Involuntary Early Retirement of a Middle Eastern General

The procession of news through the week – namely that chronicling the aftermath of the targeted drone strike and killing of Iranian General Qasem Soleimani – advanced with an agreeable flow.  The reports at the start of the week were that Orange Man Bad had spun up a Middle Eastern mob of whirling dervishes beyond recall. World War III was imminent.

Geopolitical Shocks and Financial MarketsThe recently expired general, when he was still among the quick – and seemingly in a good mood.  [PT]

Photo via harpy.ir

But after Iran’s token missile launch on Tuesday, with no American causalities, President Trump Tweeted: “All is well!”  Then, on Wednesday, major U.S. stock indices gave the “all clear” signal.  By Thursday, the Dow Jones Industrial Average (DJIA), the S&P 500, and the NASDAQ were all marching to record highs. The DJIA even came within a horse’s hair from taking out 29,000.

What’s more, the price of crude oil fell below where it was before Soleimani was killed.  No harm, no foul.  What to make of it?

According to traders, everything is awesome.  Still, we have some reservations.  Our best guess is that this week’s agreeable flow of news will be followed by a disagreeable ebb.  Conceivably, it marks the first paragraph of a new chapter in America’s forever war in the Middle East.

The stock market barely flinched (Qasem who?) and crude oil quickly gave back its gains again. Evidently, upheaval in the Middle East isn’t what it used to be. [PT]

In the interim, however, we will consider the events of the last 10 days an experiment.  Here, with little consequence (at least for now), we have been gifted a sampling of how financial markets behave when a burgeoning geopolitical crisis hits.

We posit that during the initial fog of a geopolitical crisis financial markets don’t have the faintest inkling of potential risk.

Hyperventilating Minds

Financial risk, for our purposes today, is not a quantified statistical measurement.  We are not concerned with the risk differential between high beta and low beta stocks.  Rather, at the commencement of a major conflict, risk is specific to the probability that a foundational change results which wipes away capital permanently.

Author Fred Sheehan wrote a piece titled, “War of the Nerds,” for the December, 2006, edition of Marc Faber’s Gloom, Boom & Doom Report.  Several years ago the article was still posted at Sheehan’s now defunct Au-Contrarian website.  By chance, before the site vanished, we preserved the following excerpt:

“Every generation suffers its particular fantasies.  So it was a century ago.  Investors had grown so immune to the consequences of war that bond markets from London to Vienna didn’t flinch after the assassination that provoked World War I.

“Three weeks later, in the summer of 1914, the fear premium amounted to a total of one basis point. Then, in quick order, European markets ceased to function. A notable feature of this paralysis is that nothing of substance had changed – war had not been declared by any of the parties, but by now, minds were hyperventilating.”

Perhaps the motivation for the cerebral excitement was the rapid realization during the July 1914 Crisis that complex political alliances had turned the European continent into a giant Mexican standoff.  The risk of a stock or bond market selloff was quickly overshadowed by the prospect of something much greater.  Namely, that the diabolical self-annihilation of European society itself was, in fact, just moments away.

Archduke Franz Ferdinand at the moment he was taken off the board by young Serbian nationalist Gavrilo Princip – who came across his car by sheer coincidence (the driver was temporarily lost and took a wrong turn).  At first the markets shrugged (“Archduke who?”), but the equanimity didn’t last very long. [PT]

Geopolitical Shocks and Financial Markets

It would be wrong to draw close parallels between the geopolitical landscape in Europe circa 1914 and the Middle East circa 2020.  This is not our intent.  We are merely citing this as an example of how quickly financial markets can go from fully functioning to complete breakdown.

The question, again, is how financial markets behave when a burgeoning geopolitical crisis hits.  The events of the last 10 days serve as our experimental test trial. Here is a summary of our findings, albeit of a grim comparative nature…

As far as we can tell, bond markets are quick to dismiss the risk of a foundational change resulting in the permanent destruction of capital.  For example, the yield on the 10 Year Treasury note briefly dipped below 1.8 percent on January 3 – the day of Soleimani’s death.

Iran’s level 10 boss and other government members inspect the general’s coffin and bemoan his passing. The Iranian government’s response to the assassination was quite measured and seemed primarily designed to impress its domestic audience. Alas, this didn’t really work out as planned, as a Ukrainian passenger plane was shot down in the heat of the moment. It happened by mistake, but somehow this faux-pas didn’t sit well with the citizenry, which started to demonstrate against the people in the picture. The irate population is reportedly quite adamant, defying curfews and other attempts at restricting the protests. [PT]

Photo credit: Reuters

Since then, the yield has walked back up to 1.85 percent, which is about where it was at the start of the year.  This fear premium – as bond prices move inverse to yield – was next to nothing and transitory.

After a brief selloff, stocks, as noted above, were quick to recover and move to new highs.  Defense sector stocks like, Lockheed Martin, were the real winners.  On news of the Soleimani’s death they jumped upward. Then, in the aftermath, they continued to gain.  Year-to-date, Lockheed Martin is up 6.56 percent.

Gold, while exhibiting more caution than Treasuries, has been moderately indifferent to potential risk.  On January 2, the price of an ounce of gold was about $1,528.  On January 3, it jumped to over $1,550 an ounce. Then, on January 7, gold nearly hit $1,600 an ounce.

But after President Trump Tweeted “All is well!” the price of an ounce of gold slid to just below $1,550 an ounce on January 9 – roughly $20 an ounce higher than before Soleimani’s death.

Geopolitical shocks, as we understand them, generally increase the demand for gold.  A threat to stability, quite naturally, challenges the durability of fiat money.  Those who see through the thin veneer of full faith and credit desire to hold more gold and less fiat.

Gold briefly reacted to the general’s unexpected demise, but quickly retreated again. We would note to this that buying gold in response to geopolitical news is rarely a good idea, as such rallies are invariably given back. On the other hand, a lengthy conflict that provokes an increase in government spending and more debt monetization from the Fed is a good reason to buy gold. Meanwhile, treasury notes barely twitched. [PT]

Presently, gold, as opposed to Treasuries and crude oil, is still holding on to some of the fear premium it added over the last 10 days.  Make of it what you will…

Of course, there are plenty of things that can go wrong out there these days – all is not well. Another dust-up in the Middle East financed via the printing press is certainly among them.  Place your chips accordingly.

Charts by stockcharts.com

Chart annotations and image captions by PT

MN Gordon is President and Founder of Direct Expressions LLC, an independent publishing company. He is the Editorial Director and Publisher of the Economic Prism – an E-Newsletter that tries to bring clarity to the muddy waters of economic policy and discusses interesting investment opportunities.

 

 

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Geopolitical Shocks and Financial Markets 
 

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About MN Gordon
MN Gordon
MN Gordon is President and Founder of Direct Expressions LLC, an independent publishing company. He’s the Editorial Director and Publisher of the Economic Prism – an E-Newsletter that brings clarity to the muddy waters of economic policy and targets investment opportunities for acquiring considerable wealth. The Economic Prism is written peering through a prism of free market principles, limited government, and individual liberty.

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