Terrorism, Fear & Irrational Markets

When I mention “insider trading” you probably think about the infamous Albert H. Wiggin, Head of Chase National Bank during the Wall Street crash of 1929. Mr. Wiggin had secretly structured an enormous short position on his own bank which provided suitable motivation for him to actively pursue policies that were not in the banks best interests. He pocketed a cool $4m following the inevitable collapse. Perhaps Ivan Boesky comes to mind. “Ivan the terrible” received insider tips regarding notable upcoming corporate takeovers. After opening his own brokerage firm in 1975 he specialised in – you guessed it – corporate takeovers and made millions of dollars on the back of receiving illegal information. What makes insider-trading so lucrative is the fact that it represents the antithesis of the uncertainty of financial markets. When bad things happen, the markets react badly. This may be a negative earnings print, a corporate take-over that goes horribly wrong. What about a plane flying into a sky-scraper packed with thousands of innocent people? What could you reasonably infer would be the markets response to this event? There is evidence that terrorists placed huge negative bets on the market through put option positions in advance of 9/11. In fact the German stock market [DAX] commission reported that in advance of September 11th derivative volumes were twice the normal values. According to a leading expert in this area, Dr. Hugh McDermott, put option contracts on British Airways was four times the normal volumes just 3 days before the attacks. The airliners share price dropped by almost 50% in the week following 9/11. The discussion on insider-trading opens up some broader questions from an investment perspective relating to the implications of geopolitical tension more broadly on financial markets.

Many define risk as a state of uncertainty where some of the possibilities involve a loss or undesirable outcome. The celebrated 20th century Economist Frank Knight offered a notable distinction between uncertainty and risk. Knight affirmed that uncertainty arises from an inability to measure the various probabilities of a particular outcome whereas risk involves a certain element of calculation given that the probabilities are known in advance. This is an important distinction and useful in distinguishing between the concepts of portfolio risk and market volatility. Financial markets by their nature are volatile. The fundamental reason why has a lot to do with the chaotic behaviour of market participants. We cannot understand the game of investing without gaining a deeper appreciation for the human condition. Emotion and sentiment are two powerful forces that motivate decision-making behaviours. At the micro-level this may manifest through investor self-sabotage where a knee-jerk reaction to external market noise forces an incorrect decision. Well-meaning has nothing to do with it. How many people sold their holdings at the bottom of the market in March 2021? At the macro-level fear, mis-trust and greed between nations can result in devastating repercussions on a much larger scale. The market doesn’t need an excuse to fluctuate. There is plenty of ammunition there for the moment between pandemic fears, valuation concerns, inflation expectations and a general crisis in confidence. What happens when geo-political tensions begin to simmer and I wonder if we can learn any lessons of value from our experiences of the past?

A broad definition

Broad definitions are problematic because it is difficult to assign causality to one specific group of factors. What are we talking about when we speak of heightened geo-political risks? Immediately one considers military conflicts or rising nationalism leading to populist trade policies. What about climate change or rising inequality? I think it useful for the purposes of analysis here to focus the rest of this note on a much more narrow definition of geopolitical risk – global terrorism. This pivot is important owing to the central role that perhaps the most infamous episode of International terrorism has had on the evolution of geopolitical risk. Prior to September 11th 2001 the GPR or Geopolitical Risk Index registered close to 55. Following 9/11, the average GPR doubled over the next 20 years. The GPR index is a monthly index of geopolitical risk created by two Italian academics.[1] Its relevance is based upon a count of news-related items that contain references to geopolitical tensions.  One may point to the tendency of military conflict style volatility to cluster following a major incident. 9/11 appears to be significant however in fashioning a particular market environment beset by regular and more extreme global-terror related volatility. Why is this significant for investors?

[1] Caldara & Iacoviello (2018)

Too important too ignore

I mentioned earlier that there is a crisis in confidence. What does this mean from an investment perspective? Many commentators including billionaire economist Ray Dalio & renowned historian Neil Howe argue that we are entering a profound period of structural change. Whilst huge innovation has taken place across technology and industrial production, confidence has diminished in the ability of centralised government to address society’s problems. The issues are well known. They include deepening global wealth inequalities, excessive debt, a general lack of confidence in central government’s, growing nationalism & protectionism and simmering tensions over national borders. Market participants need to feel confident in the fundamental policy [fiscal & monetary] actions of their governments, the broader economic environment and the social fabric that pulls it all together. We may be entering a dangerous period when all three of these strands of belief in the system become strained. Thirteen years after the financial crisis and global economies are still unable to deal with the normalization of interest rates. Covd-19 has escalated the global debt problem and most recently the spectre of inflation poses serious implications to Central Bank policy-makers. All of these issues have serious ramifications for broader issues relating to the hegemony of the US$, the rise of China and global stability.

Caldara & Iacoviello found that higher geopolitical risk depresses economic activity, lowers stock return, and leads to movements in capital from emerging towards advanced economies

Uncertainty = Risk

The global economy is a mass of inter-connected systems held together by policy, trade regulations, general convention based on historical principles of engagement and confidence. The system is fragile however and deterioration in confidence can have devastating consequences. Diluted confidence raises uncertainty leading key decision-makers to postpone large projects or commitments. Capital spending and investment stalls. Companies dampen their employment plans leading to less productive capacity in the economy. This ultimately feeds down the business chain as consumers become more fearful, increase saving and reduce spending. One persons spending is another person’s income and the virtuous trend south continues. Academic studies find that large increase in the GPR index result in diminished equity market returns and increased capital flows from emerging market economies to more developed markets. It is interesting to note that oil prices have a negative correlation with the GPR index [i.e. oil prices fall when the GPR rises]. The 1973 oil embargo by OPEC in response to the US support of the Israelis during the Yom Kippur war drove up the price of oil and left long frustrated “gas lines” in the US for months. This cost-push inflation emerges when the supply of the asset [oil] is artificially reduced whilst demand remains strong. Falling oil prices with rising geopolitical risks is intuitive in the context of weakening global demand through a broader loss of confidence or increased uncertainty. How does any of this help us from an investment portfolio perspective? Well, key trends emerge from the research. Firstly, geopolitics matter. Secondly, financial markets tend to front-run this geopolitical market volatility. Similarly to inflation expectations, the actual threat of heightened geopolitical risk is enough to move the markets significantly.

Pretender to the throne

Whilst geopolitical risk may impact all nations, there are clear demarcation lines in relation to the severity of the impact. There is evidence that economies with a domestic-orientation are much more robust versus those with international-exposed earnings. Ireland is particularly vulnerable here.  China has made no secret for instance of their intent to reduce and ultimately remove their over-reliance on US consumption. The colossal Belt & Road Initiative is just one policy action designed to create alternative sources of economic growth. In fact the growing influence of China has several important implications in terms of geopolitical risks. Worryingly China and the US now account for 50% of the total global spending on military hardware. China is expected to account for over 20% of global GDP by 2025. In 1995 this stood at just 5%. China is eating into US hegemony. This has implications. For decades the United States enjoyed the privileges associated with the dominant reserve currency and the world’s largest trading economy. In the past the U.S was incentivised to promote global trade and economic cooperation. The key point to take away from the diminishing role of the US in International affairs and the dilution of its hegemony is the inevitable policy response. Is the U.S as likely to champion broad multi-lateral agreements in this changing back-drop? It is unlikely and the emergence of Trumpism in the U.S is perhaps symbolic of the wider appreciation there that the rules of the game have changed.

Rise of Fear

Whenever I find myself analysing pivotal historical events, I remember the celebrated and sadly recently deceased middle-east journalist Robert Fisk. Following the 9/11 attacks, Fisk was a sole voice in posing the uncomfortable question. Why did 19 young men from Arab descent commit such an atrocity? Yet the why uncovers the truth. Why for instance has the rise of extreme populism continued unabated? There appears to be something simmering under the surface. Perhaps there is growing discontent and lack of confidence in the system itself. The connection between poverty and extremism is well established. More importantly radicalisation appears to flourish in poorer socio-economic areas where opportunities for alternatives are scarce. This emerging populism appears to offer a different strain or set of problems as a structural shift in economic growth over the last 40 years has seen the emergence of developing economies [China & India] at the expense of developed nations. A culture of economic nationalism focussing on the threat of the “other” has prospered in this environment. Globalisation and immigration are attacked as mediums of excessive change. One cannot separate the rise of China and other developing economies from the emergence of extreme populism as the disenfranchised re-engage politically. The narrative politics that dominates the US scene in particular further alienates citizens along polar opposites. Powerful vested interests including large media conglomerates further fuel the divisions.

So what can you do about it?

We have empirical evidence that heightened geopolitical tensions create a hostile environment for stocks and motivate investors to seek safe haven in the likes of gold, the Swiss franc and US treasuries. The 13 year period between August 1990 and March 2003 was a particularly active period for geopolitical tensions. Starting with the 1st Gulf war and culminating with the US invasion of Iraq in March 2003, this relatively short period witnessed a number of critical geopolitical flashpoints. In between the gulf war and Iraqi invasion, there was the 1993 World Trade Centre bombing, the Oklahoma bombing, the US embassy bombing in Nairobi and most infamously 9/11. When one looks back at the impact these events had on global stock markets there is some surprise that the sell-off was not even more extreme. If we take three of the more significant episodes [Gulf War, 9/11 & Iraq invasion] the S&P fell by 14.2%, 14.9% and just over 10% respectively. The broader global [MSCI index] fell roughly the same whilst gold and the US 10 year bond were the clear winners. When you delve a little closer into the timing of these market moves you realise that they don’t last very long at all before recovery begins. There are two important points to make here. First, the ability to time the entry & exit of these moves would have been laced with risk as negative sentiment was enough to move the market well before some of the events.  Secondly, the sharp sell-off and subsequent recovery means that “doing nothing” is probably the best decision in the end. People should remember that sitting on your hands more often than not is probably the best investments advice that you will ever receive. We are now trundling somewhat into the debate of active or passive investment strategies. The actites as I like to call them will undoubtedly highlight the massive trading opportunities available through tactically allocating capital before and during these events.

The pasites will point to the benefits of full-cycle investing through a passive strategy and to the investor graveyard that is market timing. These broad classifications of investor strategy are redundant unless aligned with specific investor characteristics. This is why the first question you have to ask yourself honestly is what type of investor am I? Do you have the time [and patience] to monitor markets on a daily basis? Do you have the discipline [and nerve] to hold positions that become uncomfortable for protracted periods? The vast majority of investors in my opinion do not. They live busy, full lives and by the time they hear about this market opportunity it has already left town. Perhaps they should allocate their capital to a purely active fund manager. Unfortunately the academic evidence supporting active asset allocation does not give me huge comfort in its merits. Successful active managers do exist. They are rare though. Persistent, successful active managers are like hens teeth.

My advice based on the evidence of financial history and geopolitical tension is simple. Unless you are a professional trader with a significant track record of managing risk exposures stay away from market-timing entries around geopolitical risks. Remember volatility is just another word for market discounting. There are strategies available to take advantage of this with less risk. Robust risk management is key.

Investment practitioners love charts. Be careful of any analysis that fits the data inside a relatively short time-frame. Why? Well such analysis is open to scrutiny if it does not account for the pre & post event. Yes I can show you Mr. Client that you would have lost 20% of your portfolio between March & October 2004 following the Madrid & Moscow bombings. How about if I just pull the chart a few clicks to the right and inevitably the market recovers. Generally, the steeper the initial sell-off, the quicker the recovery. The reason for this is simple; buyers love a bargain and with enough volume and momentum recovery is inevitable. Sure, market-timing strategies will offer huge opportunities in a volatile environment. Traders love volatility as it offers opportunities to maximise gains on the back of investor irrationality. In conclusion, we should not make investment decisions in a vacuum. For instance rising geopolitical tensions in a backdrop of strong global growth and good economic fundamentals is very different to one of slowing growth and existing negative sentiment. There is a lot to ponder but one important thing to remember: if you are not sure what to do, do nothing and you will most likely be fine.

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