Opinion

James Saft

Russia worries in a low-volatility world: James Saft

July 22, 2014

July 22 (Reuters) – Rising tensions between Russia and the
West are doing what central bankers can’t or won’t: scare
investors.

Global stock markets fell for a third
straight session on Monday, driven in substantial part by rising
tensions after the downing of a civilian airplane over Ukraine.

The U.S. blames the destruction of a Malaysian Airlines jet
on pro-Russian fighters armed by Russia, and EU and U.S.
officials are threatening stronger sanctions on Russia,
contributing to a spike in volatility and a fall in most
risky assets.

Contrast that to the mild reaction to a rare and specific
warning last week from Fed Chair Janet Yellen about debt markets
and social media and biotech shares. Or, for that matter the
relative unconcern investors have displayed about the Banco
Espirito Santo mess, which threatens the
patched-together consensus about how best to buttress Europe’s
banks.

We suddenly have a source of volatility in what has been an
exceptionally placid landscape.

On the theory that you can learn a lot about a person by
studying what they fear and why, all of this calls for a close
look at the assumptions investors appear to be making.

As ever, the first and often best answer for why a price
moved is that it ought to have, and tensions with Russia may be
no exception.

Sanctions imposed on Russia, whatever their merits, carry
with them undeniable costs for both sides. Specifically Russia
is a major trading partner with the European Union, and maybe
more importantly a key supplier of energy, one with a track
record of using energy aggressively.

Remember too that while a central bank can create more money
and easier credit, neither the ECB nor the Federal Reserve has
oil or natural gas reserves. And while the U.S. does have
reserves, there is no way for the punitive sanctions to be put
into place without a measure of blowback for the economies of
those imposing them.

GENUINE OLD-FASHIONED VOLATILITY

Perhaps the best reason events have thrown a scare into
investors is that Russia is hugely unpredictable.

Russia under Putin is not a profit-and-GDP-maximizing entity
in the manner of most nation-states, but instead something far
more unpredictable. That makes taking bets on its future
behavior much more difficult. The net result is volatility in
pricing and a higher risk premium on financial assets.

“The threat of an open Russian war against Ukraine is the
biggest tail risk to our cautiously positive outlook for the
euro zone economy,” writes Holger Schmieding, economist at
Berenberg Bank in London, in a note to clients.

“The direct loss in trade with Russia and, more importantly,
the impact of the current conflict on confidence is one key
factor which currently keeps the euro zone economic recovery a
bit more muted than we had expected at the end of last year.”

When economists, or financial commentators, are making
calculations about what Putin will do next, investors can be
excused if they decide this is not a game they wish to play. The
result is not policy-engineered volatility, or the kind that
comes from an economic surprise, but a more genuine
old-fashioned uncertainty of which most of us have very little
experience.

This also illustrates even more starkly the extent to which
investors seem to take it for granted that central bankers will
act in a risk-friendly way. Yellen arguably did her best to
spook the market, or parts of it, last week when she and
colleagues at the Fed expressed concern over some sectors of the
stock and debt markets.

This had remarkably little effect, especially given how rare
such a calling out is. More than six years into the era of
extraordinary policy, risk investors take it for granted that
their interests and those of central bankers are aligned, that
the economy can’t function without easy credit and aggressive
valuations. Yellen’s warnings about the market are undermined by
what she says about the economy, and what she’s said about not
using monetary policy to lance bubbles.

Similarly, investors in debt issued by Portugal and other
weaker euro zone nations are tending to take it for granted that
the ECB and other euro zone authorities will see to the health
of the banking system. That’s actually right and proper,
especially if it comes along with an acknowledgement that
lenders to weak banks will bear their portion of the risks.

Still, while more unpredictable policy making would be no
good thing, the extent to which the markets put faith that
everyone’s loaf will be buttered by policy is dangerous.

Higher risk premiums over geopolitical tensions are probably
justified, but these are not the only potential sources of
trouble.

What happens with Russia and Ukraine is unknowable, but
central bank support can and likely will eventually be
withdrawn.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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