Ukraine-related market jitters didn’t last long. While recent events in Ukraine represent a potentially significant threat to the geopolitical order, it took investors less than 48 hours to recover from their fears and bid stocks to new highs.
Does this suggest that events in Ukraine don’t matter to markets? The short answer is no. However, investors are unlikely to respond to the events in Ukraine without a significant escalation in violence or clear evidence linking the events to the global economy, such as a disruption of oil or gas markets. Here are two interrelated reasons why.
- Significant liquidity from the Federal Reserve (Fed), along with the Bank of Japan, has suppressed market volatility in much of the developed world. While the market’s reaction to the events in Ukraine was both modest and brief, it fits into a broader pattern. Since 2012, overall market volatility has been unusually low. Since the third round of Fed quantitative easing (QE3) was announced in September 2012, equity market volatility – as measured by the VIX Index – has averaged around 15.5, roughly 25% below its long-term average.
- Policy vs. geopolitics. Most peaks in volatility since the 2008-2009 financial crisis have been associated with economic policy issues in either Europe or the United States. Examples include the spring 2010 Eurozone crisis and the late summer 2011 U.S. debt ceiling showdown. During these two periods, volatility peaked in the mid 40s, a level not seen since. Conversely, investors have been less traumatized by what can be thought of as purely geopolitical events. For example, during the Arab Spring in early 2011, the VIX Index generally traded in the high teens. When North Korea detonated a nuclear device and threatened a pre-emptive strike in early 2013, volatility remained in the mid-teens.
It’s worth noting that equity investors aren’t the only ones dismissing the significance of events in Ukraine. Bond investors seem equally comfortable with the situation. Spreads on high yield bonds, generally considered the most economically sensitive bond sector, finished February at their lowest level since before the financial crisis. In other words, bond investors are demanding only a very small yield premium for the added risk of high yield.
No one can predict how events in Ukraine will unfold. What is evident is that if current market volatility trends continue, markets are only likely to react strongly to events in Ukraine when and if violence escalates or the global economy becomes clearly impacted. However, with the Fed set to continue tapering, volatility may revert back to a more normal range. For a sign of when this may happen: watch the bond guys. If credit spreads start to widen, equity market volatility is likely to follow. If volatility reverts back to a more normal level and events escalate, markets are vulnerable. Little risk is currently priced into financial markets, as it’s clear that investors aren’t prepared for a major geopolitical confrontation.