Should we be worried by how well global markets are performing despite rising geopolitical volatility? I think so. In my September monthly, I look at the main arguments explaining the disconnect, and argue Europe is the region we should be most worried about a disruptive correction. Here are a few excerpts.
• Far Away and Uncorrelated. Much of the market commentary has stressed that the risks that most worry political analysts—for example Russia, ISIL and Syria, Syria, an Ebola pandemic—are not necessarily central to global growth and market prospects. But small (in GDP terms)and far away does not mean inconsequential. As the debate over financial sanctions has shown, its Russia’s leverage and interconnectedness, rather than its global trade share, that makes comprehensive sanctions so powerful and potentially disruptive.
• A Sea of Global Liquidity. There is little doubt that the highly accommodative monetary policies of the United States, eurozone, United Kingdom, and Japan have provided an important firewall against geopolitical risk. Looking ahead, global liquidity will remain ample, but with the U.S. and U.K. beginning to normalize, and the BOJ and ECB going in the other direction, the divergence of monetary policies creates conditions for increased market volatility. Foreign exchange markets in particular appear vulnerable, as history suggests these markets are often bellwethers of divergent monetary policies.
• Confident Oil Markets. A stable and moderate global expansion that has limited demand, as well as the revolution in fracking and other technologies, has allowed Saudi Arabia to maintain substantial spare capacity, thereby limiting the potential for a supply disruption to roil markets in the near term (though the longer-term buffering effects on market prices from these developments can be overestimated). But it is hard to imagine that broad based turmoil in the middle east, and the possible rewriting of borders, can be achieved without a material disruption to supplies at some point.
• Europe as the Weak Link. I see Europe as the channel through which political risk could reverberate in the global economy. The standoff with Russia, or a hard landing in China could significantly affect exports, particularly in Germany. Significantly, though, Europe also faces these challenges at a time of economic stress and limited resilience. Growth in the region has disappointed and leading indicators have tilted downward. Further, concern about deflation is beginning to weigh on sentiment and investment. The persistence of low inflation is symptomatic of deeper structural problems facing the eurozone, including an incomplete monetary union, deep-seated competitiveness problems in the periphery, and devastatingly high unemployment. Homegrown political risks also threaten to add to the turmoil, as rising discontent within Europe over the costs of austerity is undermining governing parties and fueling populism. The result is a monetary union with little capacity or resilience to defend against shocks. The ECB has responded to these risks with interest-rate cuts and asset purchases, and is expected to move to quantitative easing later this year or early next, but the move comes late, and is unlikely to do more than address the headwinds associated with the ongoing banking reform and continued fiscal austerity. Overall, a return to crisis is an increasing concern and political risks could be the trigger that we should be worried about.