World War 3? A Complete Guide to Trading the Impact of Geopolitics News on the Financial Markets
A newspaper showing improving market trends
Financial markets have seen a rough few years as of late. If the COVID-19 pandemic wasn't enough, investors now face a serious threat of the impact of geopolitical tensions on the markets stemming from the Russian invasion of Ukraine.
The conflict in Ukraine has raised the prospect of a larger war between the US and Russia. It could also trigger an armed conflict between the US and its allies on one hand and between Russia or China on the other hand.. Although it's too early to tell how war will affect the US economy and stock markets, experts believe that past conflicts didn't cause long-term damage, and even if they face short-term fluctuations, financial markets are largely able to shrug it off after a while.
Here's everything you need to know about how geopolitics can impact financial markets.
Markets Often Shrug It Off
According to LPL Financial's John Lynch, geopolitical tensions have not affected the US' long-term economic fundamentals. In fact, stocks have already weathered the impact of previous conflicts.
During World War II, the Dow Jones Industrial Average gained over 50%. The US stock market experienced a 115% boost during the same period. Ben Carlson, an asset manager at Ritholtz Wealth Management, noted that the market's positive performance during the crisis was not surprising.
Another example is the situation in Ukraine, which started on February 24, 2022. After Russia entered the country, the S&P 500 dropped more than 7% in the days following the incident. However, a month later, the stock market started to recover.
So What Causes Markets To Suffer?
It's widely believed that periods of uncertainty are the most common times when the stock market experiences a decline. In 2015, researchers from the Swiss Finance Institute analyzed the effects of military conflicts in the US.
The researchers noted that when a war begins unexpectedly, the stock market tends to decline. They then hypothesized that a war puzzle causes this phenomenon.
Similarly, Mark Armbruster of Armbruster Capital Management noted that during periods of war, the volatility in the stock market gradually slowed down . Todd Sohn of Strategas said that despite the headlines about the Iran conflict, investors did not take too much notice of it. He attributed the lack of reaction to the events to how the market handled these headlines.
One of the reasons why the market is calm is due to the changes in the structure of global oil markets. According to J.P. Morgan Funds' David Kelly, the recovery from the Great Financial Crisis and 9/11 have helped calm the markets.
A wider conflict between Russia and the West could also affect the oil markets. If Russia were to shut off its gas pipelines, it could cause higher energy prices and affect the global supply of energy.
Can Geopolitical Tensions Affect Markets?
As inflation continues to rise across the world, investors become more focused on monetary policies of major economies. However, they also faced with uncertainties related to the situation in Ukraine.
Using historical data and commentary, economists can predict the central bank decisions of major economies. However, they cannot yet model the impact of Russia and the West's actions on the global economy.
The volatility index of the US government bond market, which is the bedrock of global financial markets, has reached its highest level in two years due to the Ukraine and Russia headlines.
At the same time, the cost of protecting against potential volatility in the short term has risen. According to Jim Reid of Deutsche Bank, the sell-offs caused by geopolitical events tend to last for about three weeks.
How Easing Of COVID Restrictions Can Affect The Markets
The recent easing of Covid-19 restrictions in Europe and the falling infections are expected to boost European economic activity in the second half of 2022.
According to a survey conducted by Reuters, the UK's purchasing managers' index is expected to continue to increase in Q2. The rise in the services sector's index indicates that the economy expanded inQ1. According to Investec, lifting the Covid restrictions and the falling infections is expected to boost the all sectors in the coming months.
The manufacturing sector's index is also expected to increase inQ2 as well. However, the rise in the services sector's index is still expected to be limited by the ongoing labor shortages and rising inflation.
If the UK's purchasing managers' index shows a stronger-than-expected increase inQ1 overall, it could support the case for another rate hike by the Bank of England inQ2. The pace of expansion in the eurozone is expected to be slightly slower in Q1due to the delayed impact of the Omicron coronavirus outbreak. However, it is expected to pick up in the coming months of Q2 as the recovery in Germany and France continues.
Consumer Prices In The US Are At An All-Time High
The rise in consumer prices in the US reached a 38-year high in January due to the Federal Reserve's preferred measure of inflation. The core PCE price index has been on the rise in Q1 2022.
A report on consumer spending is also expected to show a rebound in Q1 2022, following inflationary pressures fueled largely by rising crude oil prices caused by the Russian-Ukraine tension.Kathy Bostjancic of Oxford Economics noted that the annual PCE inflation rate is expected to remain at around 3 percent in the fourth quarter.
The rise in prices has put a strain on the US government and the Federal Reserve to control inflation. James Bullard, a voting member of the Federal Reserve's policy committee, recently suggested that the central bank should raise its key interest rate by a full percentage point by July.
According to the CME Group's FedWatch tool, investors are now expecting the Fed to raise its key interest rate by a quarter of a percentage point by the end of June.
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According to Mohamed El-Erian, an economic adviser at Allianz, investors have been avoiding political and geopolitical shocks in the past few years due to the belief that central banks would not be able to prevent the economic impacts from escalating.
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