Could political risk cause stock markets to crash in 2018?
Stock markets are buoyant, but political risk is all around us. Is the perception of risk worse than the reality? Here we analyse what happened during The Cuban Missile Crisis of October 1962.
Around this time of year it is common practice for investment management firms to write an outlook for the year ahead. This outlook will typically contain a reasonably upbeat view on global economic growth and corporate earnings, caveated with a list of interesting geopolitical events that could lead to economic expansion being stopped in its tracks and the bull market derailed.
This is perfectly understandable for two reasons:
1. No one wants to be proved completely wrong, and showing some caution in this respect is sensible
2. Mankind is hard-wired to hearing stories and ideas, as they help give context to complicated subjects; anything with a narrative is easier to listen to, to understand and to memorise.
Potential geopolitical events for 2018
There will be many unforeseen political events in 2018, meaning that the list below is by no means complete. However these political issues are all simmering away in the background, and could become more prominent over the next 12 months.
- a scandal surrounding Donald Trump’s Presidency
- the UK Government failing in its Brexit negotiations
- political gridlock in Germany. It is now ten weeks since they had a government — the largest economy in Europe, and the breadwinner of the EU, is leaderless
- Kim Jong-un continues to threaten stability in the Far East with increasingly powerful North Korean weaponry
- fallout from the unorthodox consolidation of power by the crown prince of Saudi Arabia, alongside a nasty proxy war in Yemen
- China’s President Xi flexing his geopolitical muscles in Africa and the South China Sea
- allegations of unwanted Russian interference, ranging from computer hacking to attempts to interfere in global elections
The big question is whether any of these political events, or those we don’t know about, could be big enough to derail the bull market we have had since 2009?
Interestingly previous history would suggest not.
What happened to markets during The Cuban Missile Crisis?
The Cuban Missile Crisis of October 1962 was arguably the greatest geopolitical scare of the past 60 years. After US spy planes spotted nuclear missiles in Cuba on 16 October, the world sat through two weeks of heightened uncertainty over whether it was on the brink of World War III and nuclear destruction. The Kennedy administration was seriously considering a pre—emptive first strike if Nikita Khrushchev did not remove the weapons, and no one could predict the Russian leader’s next move.
Ultimately, following days of intense negotiations and some less public US military concessions, Khrushchev backed down. However in a sign that stock markets are perhaps more relaxed than investors think, not all that much happened on Wall Street. The Dow Jones dropped by 5% in a week, but recovered to end the month up 1.9%. It is admittedly true that the market had already fallen almost 20% that year (having risen 18.7% in 1961), and some of this could have already been in the price, but the prospect of imminent nuclear destruction did not in itself cause anything like the sell-off you might expect.
What really drives markets?
With the value of a company commonly recognised as being its future profits discounted back to the present, a geopolitical event needs to be really significant to completely derail the equity market juggernaut. Politics typically leads to bumps in the road, many of which can be taken advantage of, but most of the time nothing too serious happens to market valuations.
Of more influence is central bank policy. If the economy is allowed to grow too fast, through holding interest rates too low for too long, this can lead to debt driven booms which cause inflation. The usual way to choke this off has been to increase interest rates, but to do this too fast can lead to debts becoming unserviceable, resulting in economic contraction.
In short, central bankers have it within their power to boost economic expansion (and therefore markets), but also the ability to make mistakes in allowing these expansions to get out of control.
Ongoing policy responses from the US Federal Reserve and the Chinese Central Bank, will likely hold the answers to stock market performance in 2018.