The recent week unfolded with a steady stream of news, particularly following the targeted drone strike that resulted in the death of Iranian General Qasem Soleimani. Early reports suggested that tensions in the Middle East were escalating dramatically, leading some to fear an impending World War III.
However, after Iran’s symbolic missile launch on Tuesday, which fortunately caused no American casualties, President Trump declared via Twitter: “All is well!” Subsequently, on Wednesday, major U.S. stock indices reassured investors by signaling a return to stability. By Thursday, the Dow Jones Industrial Average (DJIA), the S&P 500, and the NASDAQ all surged to record highs, with the DJIA nearly breaching the 29,000 mark.
Interestingly, the price of crude oil dropped below the levels it was at before Soleimani’s death, prompting the question: what does this all signify?
Traders seem to think all is well. Nonetheless, we remain cautious. It’s our belief that this week’s pleasant flow of news may soon give way to a more turbulent reality . This could possibly represent the initiation of a new chapter in America’s ongoing military actions in the Middle East.
For now, we view the last ten days as a sort of exploration. We gained insight into how financial markets respond amidst a developing geopolitical crisis.
We propose that, during the initial chaos of such crises, financial markets often overlook significant risks.
Hyperventilating Minds
Financial risk, in the context of this discussion, is not merely a quantifiable measurement. It does not concern itself with the variations between high and low beta stocks. Instead, at the onset of a major conflict, risk pertains to the likelihood of an event that irrevocably erases capital.
Fred Sheehan once wrote an article titled “War of the Nerds” for the December 2006 issue of Marc Faber’s Gloom, Boom & Doom Report. Although the article no longer exists on his former AuContrarian website, we were fortunate to preserve an excerpt:
“Every generation suffers its particular fantasies. So it was a century ago. Investors had become so desensitized to the repercussions of war that bond markets from London to Vienna showed little response following the assassination that triggered World War I.”
“Three weeks later, during the summer of 1914, the fear premium amounted to just one basis point. Shortly thereafter, European markets ceased to function. Notably, this paralysis occurred even without an official declaration of war, yet minds were in a state of hyperventilation.”
Perhaps the surge of anxiety stemmed from the quick realization during the July 1914 Crisis that intricate political alliances had transformed Europe into a precarious standoff. The potential for a stock or bond market downturn was rapidly eclipsed by the possibility of Europe’s own societal self-destruction being just moments away.
Geopolitical Shocks and Financial Markets
It would be misguided to draw direct comparisons between the geopolitical situation in Europe around 1914 and that of the Middle East today. This is not our intention. Instead, we reference this to illustrate how rapidly financial markets can shift from full functionality to total dysfunction.
The pivotal question remains: how do financial markets respond when a geopolitical crisis unfolds? The events of the past ten days serve as our experimental case study, leading us to some sobering conclusions.
Observations indicate that bond markets are quick to disregard the potential for foundational changes that could result in irreversible capital loss. For instance, on January 3, the day Soleimani was killed, the yield on the 10-Year Treasury note briefly dipped below 1.8 percent. Since then, it has crept back up to approximately 1.85 percent, aligning closely with its position at the year’s outset. This minimal fear premium, as bond prices move inversely to yield, proved to be fleeting.
Similarly, stocks experienced a brief selloff only to rebound swiftly, reaching new heights. Defense sector stocks, such as Lockheed Martin, emerged as significant winners. Following the news of Soleimani’s death, these stocks rose, and they have continued to climb, with Lockheed Martin up 6.56 percent year-to-date.
Gold, while demonstrating more caution than Treasuries, has shown moderate insensitivity to perceived risk. The price of gold was about $1,528 an ounce on January 2, jumped to over $1,550 on January 3, and nearly hit $1,600 by January 7.
However, after President Trump’s “All is well!” tweet, gold prices fell back to just below $1,550 an ounce on January 9, still approximately $20 higher than prior to Soleimani’s assassination.
Typically, geopolitical shocks heighten demand for gold. Any threat to stability understandably challenges the faith in fiat currency, prompting those who see through its fragile facade to favor gold over paper money.
Currently, gold continues to retain some of the fear premium it accumulated over the past week—distinct from Treasuries and crude oil. Interpret that as you will.
Clearly, numerous factors could misfire amid today’s intricate global landscape—everything is not as it seems. Another skirmish in the Middle East, possibly fueled by monetary expansion, remains a significant concern. Position your investments wisely.
Sincerely,
MN Gordon
for Economic Prism
Return from Geopolitical Shocks and Financial Markets to Economic Prism
