Tuesday, August 12, 2014

Global Geopolitical Risks: Is Wall Street Hypersensitive and Reductionistic?

The Dow dropped 140 points in August 5, 2014 on a rumor that the Russian military is about to invade eastern Ukraine. Three days later, amid hints of de-escalation and the end of troop “exercises” on the Ukraine border, the Dow gained 186 points. Three days later, as Russia’s president approves a deal wherein the Russian OAO Rosneft and the American ExxonMobil can begin drilling a $700 million well in the Arctic Ocean, the Dow gains 16 points.[1] Are stock analysts and Wall Street investors really so hypersensitive to day-to-day changes in geopolitical risk? It may be simply that such news sells.

Just because to events are correlated in that they both occur at the same time does not necessarily mean that one caused the other.  According to the eighteenth-century philosopher David Hume, we think we have a better grasp on causation than we actually do. In the case of positive correlation between two events, a third one could be behind both—rather than one of the correlated events causing the other. In general terms, causation may be much more complex than the human brain is naturally inclined to accept.

In the case of the changes in the Dow cited above, many analysts held at the time that a “plunge in geopolitical risks related to the Ukraine-Russia crisis leads to a rally in U.S. stock prices.” Yet how “micro” can we take such a change to be? Do rumors and hints coming out of Moscow really have such power to reverberate throughout Wall Street? If so, stock analysts and investors may have a proclivity to minimize or simply not see the tremendous inertia that the geopolitical status quo enjoys. To be sure, significant events do happen. A century before, on August 4, 1914, Britain entered World War I, the war to end all wars only to prompt Adolf Hitler into political action.

Additionally, analysts may be inclined to develop an “either/or” perceptual framework that ignores the gray areas in sizing up the relative importance of multiple geopolitical hot spots around the world. Some analysts dismissed the negative impact of the escalating fighting in Iraq and Israel even as the American press was full-blown into yet another obsession on them. The Markets in New York and Illinois may indeed have been “shrugging off” the detrimental impacts of the American bombing in Iraq and Israel’s in Gaza because the Middle East as USA Today reported at the time. Yet even though Russia can have a clear economic impact on Europe, which in turn could hamper the American economy, neither the E.U. nor U.S. is indifferent to possible impediments to oil coming out of the Middle East. Russ Koesterich, the chief investment strategist at BlackRock, said as much in maintaining that the American markets would be higher if it weren’t for the increase in geopolitical risk in the Middle East.

Interestingly, however, Koesterich also stressed that “other issues are also weighing on stocks, including elevated valuations in the U.S. market, renewed economic weakness in Europe, concerns about an earlier-than-expected interest rate hike by the Federal Reserve and recent weakness in the high-yield bond market.” It is easier to reduce the cause to one, and point the finger squarely at the particular military conflagration having the most direct line, or seemingly so, to the economies in the West, than to go back to the hackneyed, even banal, myriad of domestic usual suspects. The human brain yearns for simplicity even when the actual causation process is more complicated, and the media dutifully comply.

[1] All quotes are from Adam Shell, “If Russia Sneezes, Wall St. Gets a Cold,” USA Today, August 12, 2014.