Geopolitics & Black Swans
In this lesson we will cover:
– How politics and geopolitics affect markets
– How Black Swan events affect the markets
– Why geopolitical stability is important to investors
Many of the sharpest moves in financial markets were caused by political, geopolitical or Black Swan events. As an example, the Brexit vote provided high volatility as the successful Leave campaign was totally unexpected by the markets.
“Black Swan” events are unpredictable circumstances that have potentially severe consequences. Black swan events are characterized by their statistical unlikeliness, extreme rarity, their severe impact, and widespread insistence by the media, pundits and economists that they were obvious in hindsight.
Uncertainty & Volatility
Using Brexit as an example: the UK’s referendum on EU membership, wherein a largely unexpected ‘Leave’ vote caused a severe drop in the British pound and led to speculation that the European Union might disintegrate. Together with the election of Donald Trump as US President, these two historical events highlighted a rejection of the established neo-liberal status quo, and called into question the accuracy of political polling.
Although trend traders require volatility to make profits, too much volatility can cause wild swings in the market, as the participants are unsure as to what will happen next. Trading during these times requires a level head and an abundance of caution. It may even be better to avoid trading after these events occur completely on the affected instruments (e.g. Pound Sterling/US Dollar (GBP/USD) and Pound Sterling/Euro (GBP/EUR) in the case of Brexit).
Black Swan Events
A Black Swan event is a metaphor that describes an event that comes as a surprise, has a major effect, and is often inappropriately rationalised after the fact with the benefit of hindsight. The term is based on an ancient belief that presumed black swans did not exist – a saying that became reinterpreted to teach a different lesson after black swans were discovered in the wild in Australia.
It should be noted that many analysts regard Brexit itself as a Black Swan event.
In addition to Brexit, other Black Swan events in the financial markets include:
– The Global Financial Crisis (GFC), 2008
– The Dot Com Bubble, 2000
– Black Thursday, 1929
Although Black Swans are inherently difficult, if not impossible to predict, you can at least attempt to mitigate their effects by paying attention to the news headlines, and avoiding trading altogether when there is likely to be instability. For example on the day of the Brexit Referendum announcement, you might have avoided trading any GBP or EUR currency pair.
Change & Markets
A change in government, geopolitical events or Black Swan events often leads to a different approach to monetary or fiscal policy within a country, which can positively or negatively affect financial markets. The dollar surged after Trump won the election, as the market expected a looser fiscal policy to force the Federal Reserve to raise interest rates.
Generally speaking, many believe that the more a government spends, the more the economy will grow, which could lead to a rise in inflation.
Additionally, political parties who are regarded as more fiscally responsible or more concerned with promoting economic growth could boost both the country’s stock market and currency.
When a government that is seen as “economy-friendly” is in danger of losing its position in power, traders and investors may react nervously and sell their currency or stocks.
Stability
Stability is something that financial markets appreciate. Uncertainty is something that can have a negative impact on stock markets or a currency.
However, a change of government is not the only factor when it comes to politics. In 2012 the Eurozone was on the verge of collapse due to the European Sovereign Debt Crisis (also claimed by many analysts as a Black Swan Event). Greece was almost bankrupt and EU leaders couldn’t find a solution. A similar scenario occurred in 2015 when Greece came close to leaving the Eurozone, resulting in high volatility in markets such as the DAX, CAC40 and other European markets.
It wasn’t until a political deal was reached in Brussels that the market was eventually stabilised. Although the measures put in place were far from perfect, the sense of stability caused a significant rally.
Politics, geopolitics and Black Swans can have enormous effects on markets – especially in today’s global, interconnected world. It is important to keep an eye on political trends as part of your fundamental analysis.