Are markets right to be spooked?

As market volatility increases on the back of mounting geopolitical tensions, can this be dismissed as ‘short term noise’ – or is there more at work?

  • Geopolitical tension has seldom proved to have a significant long-term effect on markets.
  • But periods of benign volatility are often followed by periods of significant volatility
  • Market prices remain high and trade wars a significant risk

The recent turmoil – over Russia and Syria and the US’s high-handed style of diplomacy - has markets spooked. Volatility has increased swiftly – the S&P 500 has racked up 27 daily movements of more than 1% in 2018, compared to an average of 75 per year over the past 20 years. But are they right to be spooked?

On the one hand, geopolitical tension has seldom proved to have a significant long-term effect on markets. Of all the various elements that affect stock prices, the influence of political turmoil is usually short-lived. This has been seen through the gulf wars, for example, where markets sold off rapidly, but revived reasonably quickly.

However, there is rather more on the ‘reasons to be spooked’ list. Research by AJ Bell shows that periods of benign volatility, like the one we’ve just experienced, are often followed by periods of significant volatility.

Russ Mould, investment director at the group, said: “Similar quiet periods to match the subdued stock market action of 2015-2017 – such as 1994-1996 and 2004-2006 – were followed by a real spike in volatility which ultimately heralded the market tops of 2000 and 2007. One lesson investors can therefore draw from history – were it to repeat itself – are that we haven’t seen anything yet in terms of volatility.”

Then there’s the trade element. There may not be a great deal of risk in geopolitical problems, but a trade war is a different matter. That has a significant and enduring effect on companies’ ability to do business. It may all be bluster and noise, it may only affect certain industries, but it makes investors fear that their investments aren’t safe.

There are other more prosaic considerations. The US tax cuts are likely to prompt more rapid growth, which in turn may prompt higher interest rates. The US yield curve is currently at its flattest point in a decade and its inversion has typically pointed to a recession. If inflation rears its head, and interest rates have to rise more quickly than expected, the markets might roll over.

Valuations remain high. Notwithstanding the recent volatility, markets remain at or near nine-year highs. Investors have, to some extent, forgotten about risk because they haven’t needed to worry about risk. However, as the tide goes out, many may be found to be swimming naked.