Geopolitical shocks and markets: Ukraine

by George Hatjoullis

The Ukraine situation is having a market response. The dynamics of such a response are however a little more complex than the glib ‘safe haven’ explanation trotted out by tired hacks. Geopolitical shocks rarely have a well-defined implication for financial markets. Ukraine is just such an event. Russia takes over Crimea. It may take over a bit more of Ukraine. Much righteous indignation from the ‘West’ but so far not much action. What happens next? No one knows and this is the problem. The event has created uncertainty that does not fit within a well-defined probability density function. It is impossible to make probabilistic calculations that are meaningful. When things become uncertain we retreat to a ‘safe’ place.

Safe, however, is relative. If I am an US based investor that has gone short Yen, then it is safer to cover this leveraged position ,so I buy Yen and sell USD. If I am a Japan based investor holding overseas bonds I might sell these bonds and repatriate my funds, buying Yen in the process. The Yen rallies but this is not because Japan is a ‘safe haven’ in relation to the Ukraine. After all China might take the opportunity of a distracted US to rattle its sabre in the East China Seas a little more. The Yen rallies because there are position adjustments in a state of uncertainty that result in Yen buying. It is positions and the reference position of investors that determines the bulk of the market response.

There are of course traditional safe havens; gold and the Swiss Franc. However, how safe is gold? Physical gold is safe if you have somewhere to store it, safely. Gold derivatives are only as safe as the counterparty. The Swiss Franc is safe as long as all countries recognise its neutrality. So far this has been the case under very extreme scenarios. The market reaction in relation to these two assets is largely knee-jerk. Another traditionally safe place to be is the government bond of your own state. This is obviously not true for Ukraine citizens. It is also not obviously true for eurozone citizens. It is true for US, UK and Japan citizens. If you think the geopolitical shock could be inflationary they also offer index-linked debt.

Market reactions will nevertheless largely reflect exposed positions. The most striking aspect of the Ukraine event so far has been how little market response there has been which would imply that leverage is not excessive and exposed positions are not excessive. There is time for further market response as the situation develops but the initial reaction is muted. Unless there is a serious possibility of military intervention by the ‘West’, the Ukraine event will recede and normal service will be resumed. I give a zero % probability of military intervention, but I have been known to be wrong.