Is A Russian-Ukraine Conflict Discounted In To Markets?
After a
brief flight from risk and run for cover, equity markets and bond markets are
adjusting to the idea of conflict on the Crimean peninsula. But are
these markets accurately accounting for the rise of a real conflict between
Russia and its former territory? Given the growing hostilities between the two
nations, and US equity indices heading back toward record levels, it is hard to
accept that a real conflict is priced in to markets.
As of this writing, Russia is amassing troops and running exercises near Crimea and the Ukraine has "eliminated" some "terrorists" that had set up road blocks. These are, so far, relatively minor incidents. However, wars have been started for less, especially, if one party is motivated by hostilities. Through referendum, Crimea has voted for its secession from Ukraine, which Russia acknowledges but the European Union and the United States do not. The US accuses Russia of inciting unrest in the region which Russia strongly denied. Over half of the Crimean population is of Russian ethnicity, accounting for why a referendum would be successful. So why the hostilities, why now? Russia, and Putin, its leader, could well be motivated by both economic and military interests. The ports in Crimea represent access points that represent maritime routes to the Mediterranean and to key Russian military bases in Crimea. As Ukraine distances itself from Russia, Russia may fear losing access to these strategic routes and its military bases. The area also has significant energy reserves in the form of gas. Is this incentive enough to start a potential military conflict with a heavily nuclear-armed opponent? It could be if Putin's ego is large enough, and the recent winter Olympics reflect at least that much.
Why Do Markets Care?
Markets dislike uncertainty. It could be its most detestable concern. Markets can handle most any issue that arises and discount it in, or price it in, accordingly. What markets struggle with mightily, is the unknown. How do you price in something you cannot evaluate or measure? That's what markets struggle with the most and why political and military hostilities pose such a threat to markets, both equity and fixed income. Typically, uncertainty is reflected in markets by a flight to quality, which is reflected in a sale of risk assets and the purchase of US treasuries, seen as a safe haven. The implications are immense. The importance to money managers is return performance, and to consumers is interest rates. A flight to quality can lower mortgage rates which benefit homeowners and homebuyers.
Is the Possibility of a Conflict Priced In to Markets?
The point of the article is to explore whether or not the possibility of conflict is accurately reflected in both equity and fixed income markets. Given elevated equity levels near all time highs and relatively high interest rates, as of now, it seems markets are not truly reflecting a real conflict is on the horizon. Where should equities and interest rates be? It's hard to say what would reflect a proper accounting for this possibility but some risk premium should be evident in both markets to account for possible hostilities. Equity indices should reflect some spread below where they could be absent any conflict whatsoever, and fixed income assets should show some spread above where they should be. The inherent problem with this logic is that, since the economic recession and extreme Federal intervention to stabilize markets, it's difficult to ascertain whether markets again expect Federal intervention in markets if a real conflict emerges and therefore is not discounted in properly.
Conclusion: The Fed Saves the Day...Again.
After a nearly unstoppable five year run, the bull market continues its stampede with the Fed tailwind behind it, and no conflict is insurmountable from the markets perspective. The possible Russian-Ukraine conflict will prove this again. Investors will cavalierly place their bets that any hiccup caused by geopolitics will be swept away by more liquidity and more artificial stimulus. This observation is not cynical but based on the past five year history of how markets are behaving in the current environment. What is unknown, and the market should despise is, what will be the cumulative effect of looking past all of these market hurdles, that the Fed has offered a soft landing, when it steps back?
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