Contrarian, Special Situations
Contributor Since 2013
Rising international tension is threatening to increase market volatility, but Emerging Market equities (EEM) and US equities (DIA, SPY, QQQ) exposed to those markets seem to be ignoring it. They also seem to be ignoring the crumbling of Globalism. By "Globalism", I mean an international consensus that countries are intimately dependent on the global economy and positive relationships with other nations. The decline in Globalism is a threat to international stability and raises the risk of war. Traditionally, traders do not worry about the potential for wars, revolutions and other geopolitical disruptions in deciding whether to hold equities with exposure to the Emerging Markets. But now they must. Complacency about the rising risk of international conflict over the Ukraine Crisis is potentially dangerous. This is a clear departure from the past. Arguably since World War I, the start of a war hasn't caused a dramatic market decline. Even Pearl Harbor didn't drop the US market more than ten percent. Accordingly in modern history, regional wars, such as the Bosnia conflict, had minimal effects on the financial markets. Viewed as isolated events, they had little long term significance. Even recent wars in the Middle East such as the Gulf Wars, the Afghan Invasion, the Israeli-Lebanon war, or the Arab Spring revolutions were viewed by the equity markets as short term events. Investors often used them as buying opportunities consistent with Rothschild's saying "The time to buy is when there is blood on the streets."
But, we may have reached a turning point. Although international rhetoric has worsened, we are still near a high point in international peaceful relations and in the global equity markets. The Cold War has been over for over twenty years. Afghanistan and Iraq are winding down. International financial coordination has been strong in getting the world out of the Global Financial Crisis and the Europeans out of their debt crisis. But simultaneously, strains in international relations are heading toward a breaking point. The economic and political ties which restrained nations from using war and war-like tactics to achieve power grabs are faltering. I realize this doesn't sound like your typical economic or investment analysis which goes through the macro-economic prospects for regional or global growth and how it might impact company earnings. What I'm addressing is the potential for bigger events, those which could unhinge the foundations of Globalism. The loss of Globalism would have far reaching effects on global growth and wealth.
Consider the large cluster of economic and political crises which have hit the world in the last decade or so. There were several serious geopolitical disruptions: September 11th. The Afghan War. The Iraq War. The Arab Spring. The Syrian Civil War. The Russian invasion of Georgia and now, Ukraine.
Around the same time, there were several financial crises: The Asian-Russian Currency and Financial Crisis of 1997-1998. The stock market decline starting in 2000. The Global Financial Crisis of 2007-2008. The European Debt Crisis of 2010-2012. The American Debt Ceiling Crisis of 2011.
Just because the financial and political crises happened together doesn't mean that one caused the other. However, the tone of international relations and the support for Globalism is deteriorating. I would argue that these clusters of financial and political crises are an early warning sign that failures in global capitalism are increasing global instability. There is no definitive proof of this because countries don't say why they attack each other or why they undergo revolutions. Wars are unpredictable. They can start without warning.
But when trends of major geo-political crises accompany economic ones, as happened over the past decade or so, it's worth taking notice. The atmosphere of internationalism is becoming poisonous; the Russian invasion of the Ukraine is the most recent and stark example of this. Traders need to acknowledge that the prospect for future wars and related economic chaos has increased significantly. Global political and economic stability can no longer be viewed as guaranteed, and geopolitical disruptions as isolated moments of market volatility. It is now more likely now than before the Russian invasion that one morning we'll wake up to a market dislocation due to war.
Why is the Russian invasion of the Ukraine the turning point? Russia is a former Superpower. The fact that Russia is engaged in unilateral war and war-like tactics legitimizes those tactics for other would be aggressors such as Iran, China or North Korea. In addition, even though there's a lot of diplomatic outrage by the United States and its allies, so far it seems ineffective. I'm not trying to get into a political argument about what the right US policy is. I'm trying to point out that the de-globalization of international attitudes - Russia can invade another nation while the United States doesn't stop it--means that both Superpowers no longer view global stability as critical for their own self-interest.
One may personally believe that the US shouldn't intervene or that Russia is somehow justified in what it's doing. But traders must consider that the risk of miscalculation related to this situation (and others as discussed below) raises the likelihood of an unforeseen major conflict which would result in a significant market decline. If we wake up to headlines that Russia is invading the rest of Ukraine, couldn't that set off a currency crisis in the Euro, as investors fear that a confrontation between Russia and NATO is imminent? Or, what if the Chinese seize the Senkaku Islands? The Asian markets could plummet as the threat of armed conflict looms as well as regional and possibly global trade wars.
Some (including Warren Buffett) have argued that war is good for the markets. Even though I'm not predicting a world war, consider that when World War II broke out and the stock market rose shortly thereafter, it was near generational lows. Now it is near all- times highs. Moreover, in 1941, world governments had almost no debt. Now worldwide public debt is near $53 Trillion. Countries are in no position to borrow more for wars. So, if they buy armaments, either they'll cut back in other areas, which would be recessionary, or they'll dilute their currencies, which would be inflationary. Neither is good for the equity markets.
Adding the proverbial fuel to the fire, consider these other destabilizing situations which could escalate if Russia, China or the US won't intervene to stabilize them:
1. Iranian nuclear ambition coupled with support for violent extremists in neighboring countries which threaten Israel and several Gulf States.
2. Higher frequency of North Korean provocations toward South Korea and Japan coupled with its development of missile technology aimed at being able to deliver a nuclear attack on the United States.
3. Chinese territorial assertion in conflict with Japan and other East Asian Nations.
4. A Syrian civil war which continues to foment instability throughout the Middle East.
5. The myriad of possible escalations related to Russia's further instigation of unrest in Eastern Europe.
It's very difficult for a trader to predict a war or fully anticipate its effects. But my point is that investors should consider reducing their equity allocations to emerging markets as a result of this rising tension. When a war starts there may be little or no time to adjust to a conflict which starts literally overnight.
Here are a few thoughts to consider as to why this trend of increasing risk of conflict is likely to stay.
Previously, Superpowers would have stepped in to stop brewing conflicts from turning into bigger uncontrollable wars. In crises like the Cuban-Missile Crisis, or the Yom Kippur War, the Superpowers restrained themselves and their allies from escalating these conflicts. Maybe it was because their leaders lived in the shadow of World War II and knew that the possible consequences of war in the nuclear age was the unthinkable: total destruction. But, today, as World War II recedes into history, some of the dominant powers seem willing to take risks to grab power. Maybe they have forgotten what large scale war looks like and don't fear nuclear escalation.
In addition, they appear willing to risk suffering economic damage as a result of their war like tactics. Maybe that's because countries like Russia and China have abandoned their democratic movements and reverted back to autocratic rule. Leaders, such as Putin, don't feel susceptible to international pressure.
At the same time, those aggressive powers don't fear the United States because Americans don't want to get involved in foreign affairs after two exhausting wars. Whatever traders may personally believe about this new strain of American Isolationism, it has a destabilizing effect on global security. When the "policeman of the world" withdraws its presence, potential aggressors and victims alike are more likely to pull the trigger, acting either out of opportunistic aggression or pre-emptive self-defense. The Israelis might be more willing to attack Iran, believing that they have no choice because neither the US nor Russia will stop Iran's nuclear drive. It's also worth considering that this new American isolation may be rooted in its dissatisfaction with its democratic and free market capitalistic institutions. It isn't a coincidence that this new isolationism has arrived at the same as the US government (through the Fed) had to take over the free markets to save them and after several vitriolic and divisive political confrontations (e.g., the Bush/Gore election of 2000, the Obama/McCain election of 2008, the Debt Ceiling Crisis of 2011 and the Fiscal Cliff confrontation of 2012). If Americans feel free market capitalism and democracy aren't working for them at home, why would they fight for them abroad?
Investors should consider that rising international tensions occurring with the decline of Globalism may lead to more equity market volatility. A trend of increasing wars, revolutions and other geopolitical disruptions may dampen risk appetite. More democratic countries with free market economies may be threatened and some may move (or be taken) toward authoritarian government controlled economies. This reduces global growth and the global wealth effect. More formerly peaceful emerging market countries may find themselves in the throes of conflict, dragging down global economic growth and business confidence.
It's likely that international institutions of financial stability, such as the IMF, may have more difficulty getting consensus (and funds) to stop financial crises. Russia's absence from the G-8, while not critical to its functioning, may weaken international support if there is another debt crisis in Europe.
Until a new consensus for Globalism emerges, investors should review their holdings in global risk assets and consider awaiting better buying opportunities as more disruptions may cause market declines.
Disclaimer: Further to any disclaimer for the site on which this article is posted, please be aware that the author is not a registered investment adviser (or representative thereof). The content presented in this article is opinion only, and should not be relied upon by the reader in making investment decisions. The reader should base any investment decisions on his own independent research and analysis entirely at his own discretion and/ or seek advice from a professional. No content published in this article constitutes a recommendation that any particular investment or investment strategy is suitable for any specific person.
Disclosure: I am short QQQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: In addition, I am long the QID and SQQQ. I trade these positions daily, adjusting my holdings and may initiate more positions.