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The raised level of investor concern about geopolitical risk is evident from defensive positions and the low level of developed market government bond yields. Five EU bond markets and Switzerland now have negative yields for two-year maturities, while 10-year US Treasury and Japanese government bond yields are close to their lowest levels this year.
However, the focus of investor concern has shifted somewhat from the Middle East to Ukraine. This is shown in the reversal in oil prices, with Brent, the international benchmark, dropping from close to $115 per barrel in late June to about $101 currently. Speculative positions in oil markets have fallen as perceptions have risen over the extent of oil supplies and the recognition Middle East conflicts have not significantly disrupted output.
In contrast, pressure on Russian capital markets has grown as the conflict in eastern Ukraine has intensified.
After the flat GDP figure for the eurozone in the second quarter and with the estimated August inflation number at only 0.3 per cent, concerns have focused on the potential impact of the Ukrainian situation on investor confidence.
The eurozone indices for industrial and consumer confidence have all shifted negatively in August, while the Markit eurozone manufacturing index slipped to 50.7. Geopolitical factors have been reflected in the depreciation of the euro against the US dollar towards $1.30 and in the low government bond yields. But given expectations of further easing by the European Central Bank they have not been discounted in eurozone equity markets.
Arguably, one area where investors are being complacent is the UK where clear risks are apparent. After the European election results, investors have to recognise that the electoral landscape has changed to a less constructive approach to the EU.
There is widespread confusion among global investors as to what will happen to the UK economy and markets in the event of a Scottish vote for independence, which the opinion polls suggest is increasingly close. The threat to the Conservatives from Ukip in next May’s general election could lead to a Labour-led government. In the event of a Conservative-led government, there are the uncertainties of EU renegotiations and a possible 2017 referendum where a vote to remain in the EU is not assured.
Although there are limited examples of countries successfully separating, for example, the Czech Republic and Slovakia, there is significant uncertainty in the short term over the Scottish vote. Issues include the currency, Scotland’s membership of the EU, banking supervision, the size of the banks relative to the Scottish economy, the responsibility for gilt debt repayments, ownership of energy assets, potential capital flight, the outlook for fiscal deficits, Scotland’s credit rating and, critically, its growth outlook.
These can be resolved over the long term, and Scotland’s outlook will be determined by its ability to generate investment and employment in sectors where it has a competitive advantage. There are clear models and examples on how to achieve economic success and, conversely, failure.
In the short term, however, a vote for independence will generate increased volatility, given the uncertainties above and there is clearly a risk initially of a sell-off in the gilt market and sterling. Arguably, 10-year gilt yields at approximately 2.4 per cent are not discounting a “yes” vote; there is no real precedent in quantifying the potential market downside but it would not be unrealistic to assume a spread over 10-year German Bunds widening to more than 200 basis points, with sterling against the US dollar reversing to well below $1.60.
One critical question will be the regulation of UK-owned banks registered in Scotland, and volatility may emerge in the bank credit default swap market. Given the international nature of the FTSE 100, the impact on UK equity markets should be limited, although, inevitably, the FTSE will underperform other markets in the short term, with investors cautious on positions in companies with major operations in Scotland.
Arguably, the 2015 UK general election and the prospect of a referendum on EU membership are more profound challenges to UK capital markets. An exit from the EU would clearly have a negative impact on inward investment, trade flows and the UK’s ability to carry out business in the EU.
London as a financial hub would be threatened, given its reduced ability to carry out transactions in the EU. The models that conclude that the UK would benefit from an EU exit make a number of optimistic assumptions about the UK’s ability to trade elsewhere in the world and its ability to attract inward investment.
One has to conclude that market perceptions of geopolitical risk can shift rapidly and UK markets have to be braced for the possibility that investor concerns will switch to the UK.
Robert Parker is senior adviser to Credit Suisse