A confrontation escalates between Beijing and Tokyo over disputed islands in the East China Sea, known as the Senkaku in Japan and Diaoyu in China. Japan protests against their inclusion this week in a Chinese “air defence identification zone”.

Military analysts warn the conflict could spiral accidentally into open war. As far as markets are concerned, however, they could have been talking about a Martian invasion. The Japanese Nikkei share index is up almost 1 per cent since Friday, markets elsewhere barely noticed.

Investor shrewdness? Recklessness? Or another perverse consequence of quantitative easing by the US Federal Reserve, Bank of Japan and other central banks?

The answer matters a lot. Global QE has driven investors into riskier assets. But mispricing of political threats could prove particularly dangerous as advanced economies struggle along slow growth paths and the Fed starts unwinding its exceptional economic stimulus measures.

Political events rule

Anyone watching markets since the start of US quantitative easing in 2008 might conclude they have become preoccupied with economic news – the latest actions by central banks or data releases. In fact a striking report last week by Citigroup argued the most volatile trading days in US stock markets have been triggered by political events.

This year’s biggest daily rise (albeit from a low basis) in the Vix index – the Wall Street fear “gauge” of expected stock market volatility – followed February’s inconclusive Italian elections. Other noticeable spikes have accompanied political turmoil in Egypt, North Korea’s threats of war, and Standard & Poor’s downgrading of the US’s credit rating in August 2011 because of Washington’s malfunctioning politics.

Political risks could emerge as a bigger theme in 2014 as the Fed “tapers”, or scales, back its asset purchases, Citigroup argues. “Increased liquidity is about to depart the scene, but the underlying structural political risks remain largely unchanged,” its analysts say.

In Europe, precarious governments facing chronic economic problems in Italy and Greece could collapse. In the US, the gridlock over fiscal policy consistently tops investors’ lists of the biggest threats to the global economy.

The Vix index’s sensitivity to global events highlights how interlinkages remain strong, despite the post-Lehman Brothers fragmentation of markets. With the US at risk of being dragged into the escalating conflict between Japan and China, the world’s three largest economies are all involved.

The problem is that pricing such risks before they materialise is “non-linear” – or erratic – especially for investors with short-term horizons and arguably more so as a result of global QE. The lesson learnt from this year’s stand-off in Washington over the US debt ceiling was that even when there is a real risk of a catastrophic outcome, those who sell miss the subsequent relief rally. With the Fed continuing to support asset prices, the sensible option was for investors to do nothing – even though, ironically, the lack of pressure from financial markets may have encouraged politicians’ recklessness.

Martians discounted

Assessing political risks is also arbitrary. The threat of war does not feature on the list of the 15 most important “extreme risks” compiled recently by Towers Watson, the consultancy. At the top of its long-term worries, based on likelihood, impact and levels of certainty about their effects, are: a water, food or energy crisis; a prolonged period of economic stagnation; and global climate change.

Reassuringly, the threat of an alien invasion is also excluded, even though Towers Watson describes the risk as “potentially existential” and having an impact “affecting all future generations”.

Yet some global security analysts regard the potential for conflict over the Senkaku/Diaoyu islands as the most underpriced of the foreseeable geopolitical risks. The counter arguments I have heard this week are that this is a long-running dispute which occasionally blows up causing market ructions that prove shortlived, and that neither side has any interest in war. There was a bigger market reaction last year, but uncertainty was higher then because of looming Japanese elections and the change in China’s leadership.

This week’s reaction was also muffled by the simultaneous interim nuclear deal with Iran, which reduced the dangers of a Middle East conflict. Investors see Beijing’s new reform agenda as supporting economic growth and reducing systemic financial risks. Japanese stocks, meanwhile, continue to ride the waves created by aggressive Bank of Japan QE and a weaker yen. The dim prospect of a possible conflict over distant islands is easily ignored.



Letter in response to this article:

If markets could defend themselves / From Mr Jonathan Allum

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