The Return of Geopolitical Risk (the US and Iran Again)

For almost the entirety of this past year, the dominant force of motivation among investors fit within a rotation of just three major themes: trade wars, growth concerns and monetary policy. Even when these matters weren’t under full steam, their influence and too many instances of sudden changes in the fundamental weather meant that they lack of bearing led to a similar absence of conviction in speculative performance – momentum if not direction. All three of these matters stands to hold considerable influence over the global market going forward; but for now, there is a pause in their respective tempest. Just in time for a familiar alternative risk to step in: geopolitical uncertainty. 

Compared to trade wars or the Brexit which are more specifically a controlled break in economic relations, I consider geopolitical risks specifically issues that threaten the chance of escalation to a full-blown military conflict. The tension between the United States and Iran has been on the rise since the former announced that it was backing out of the Nuclear Treaty (JCPOA). Since then, we have seen plenty of threats and even actions to threaten oil shipping, but the measures were such that breaking the cycle of escalation wouldn’t threaten one side or the losing face. That may have very well changed this past week when the White House approved a drone strike on a convoy in Baghdad that killed Iranian Major General Qasem Soleimani. President Trump and officials stated that the decision was made to head off a planned attack on US military forces, but reasoning doesn’t curb the threat should Iran retaliate. 

The country has said that it was prepared to attack military targets while the US President said Saturday they were already targeting 52 Iranian sites should the country seek reprisal. The implications of hot or cold wars are extremely variable but the worst case scenarios can be severe for economies and financial markets. Such uncertainty is the very definition of risk. This situation may plateau allowing the market to simply lose interest over a long enough period. Then again, it could also catalyze without warning. How willing are investors to discount the uncertainty and how well hedged are they for greater risk? 

Central Banks are Trying to Head Off Carry Over Trade War Risk 

Trade relations seem to be thawing to enter the new year – or at least some of the more potent threats have yet to be acted upon – but that doesn’t mean the economy is imminently positioned to resume the carefree climb that existed before the manufactured hardship was applied. The impact from nearly two years of rising trade barriers has material carry over influence economically and some of the more critical pain absorbed in previous months may very well prove permanent. Consider the agricultural purchases that China is supposedly set to pursue in order to meet the Phase 1 trade deal and for which the government has supplied large subsidies to stabilize the industry during the trade dispute. Farm coalitions have warned that even if the tariffs were fully lifted – a prospect well into the future – they may never see their relationships reestablished. Sentiment (business, investor, consumer) has a lot to do with this equation, which makes the open threats along more established and critical lines like between the US and EU added pressure that we do not need. 

I visualize this as a large vehicle that is pumping its breaks but momentum continues to carry it closer to a critical cliff (an economic stall whereby external catalyst is no longer the critical ingredient). The world’s largest central banks no doubt see it in a similar fashion. Most policy statements or minutes have stated the concern around trade conditions as a serious external risk and many individual policy officials have expounded upon the unique risks that exist. This is likely the principle motivation behind the largest to add accommodation or hold open existing generous accommodation policies. The ECB was seeing unflattering growth figures and the uncertainty of Brexit, but is that enough to justify restarting QE and pushing benchmark discount rates even further into negative territory? And despite saying it anticipated no changes to policy last year before each meeting, it cut three times. 

Preemptive policy like this does not offer tangible benefit – rather it is the absence of greater pain that may or may not have been realized. On the other hand, there are very real costs that continue to accumulate like cholesterol in the veins of the financial system. My top concern was addressed in the FOMC minutes this past Friday when it was reported that some of the US bank’s members worried that extreme accommodation was encouraging excessive risk taking. Unlike inflation or employment (their dual mandate until they decide to change the mix), investor sentiment can turn quantitative to qualitative with no warning. 

Mind the Means for Market Performance to Gauge Persistence 

Why should we care what is driving markets higher so long as we are positioned to take advantage of the climb? Even dyed-in-the-wool analysts ask themselves this question at one time or another. Many pure technical traders answered this very quandary some years ago with a ‘we shouldn’t’ and likely never looked back. However, whether chart traders, analysts with a crisis of faith or hedge fund managers frustrated that market norms have been upended; everyone should account for the prime motivator of the masses. Knowing what is urging the masses to a bullish or bearish (or neutral) environment can tell us when the a trend will stall, when congestion turns to a break or we fast track a reversal. Timing sudden reversals or distinguishing temporary pauses from a stalled trend can be a serious struggle for many investors that shun the fundamental map. Keeping course doesn’t make you immune to the struggle, but it can certainly help avoid the worst of the pitfalls. 

I’ve said before, but it warrants repeating: the fundamental overview of the market is a factor of accumulation. There are thousands of motivations among traders to take or cut a position at any given time. Their collective actions renders the prevailing winds. Yet, not all of the causes are wholly unique. There are often dominant themes that dictate the actions of large swaths of investors. Trade wars, monetary policy shifts and recessions can be consuming matters that enough of the market responds to make it a systemic driver. Working out what dominant themes are actively controlling the reins or are lurking on the fringes can make analysis far more effective. Further, appreciating that the vast majority deployed in the system is controlled by participants that don’t have short-term duration and who don’t even consult charts help us to avoid the frequent cry ”these markets just don’t make sense!”