The disconnect between Teflon-coated financial markets and the growing catalog of geopolitical and economic risks has rarely been wider - or more puzzling. Investors and policymakers appear to be living in two parallel universes, and there is no sign of them converging anytime soon.
As the world’s policymakers, gathered here in Washington for the International Monetary Fund and World Bank Spring Meetings, fret over global imbalances, energy security, war and the breakdown of the world order, investors are barely blinking.
Because of the Iran war, growth this year will almost certainly be lower than it would have been otherwise, while energy costs, inflation, uncertainty and perhaps even interest rates will be higher than projected on February 27 - the day before the conflict broke out.
Yet the S&P 500 and the Nasdaq have roared back 11 per cent and 16 per cent, respectively, from their lows of March 31, and on Wednesday, both indexes hit their highest levels ever.
There are a host of plausible explanations for this apparent disconnect.
One is psychological. Since 2008, investors have been taught that it almost always pays to “buy the dip” because, ultimately, authorities will step in to support asset prices and preserve financial stability - a modern-day version of the so-called “Greenspan put.”
The monetary and fiscal “bazookas” launched in response to the global financial crisis, euro zone crisis, and COVID-19 pandemic are proof of this.
Then there’s the “TACO” (Trump Always Chickens Out) trade - investors’ bet that the U.S. president will dial back his most egregious threats. It has proven to be a reliable strategy thus far. As one policymaker put it, markets are now “de-sensitized” to Donald Trump’s fiery rhetoric and controversial policies.
Meanwhile, there’s the artificial intelligence boom, bulletproof corporate earnings forecasts, and Wall Street’s decades of outperformance. They have all put a solid floor under U.S. equities, or perhaps we should call it a springboard?
Add all that together and you can see why selloffs are short-lived, even when geopolitical and policy uncertainty is so high, and risks are as diverse and plentiful as they are today.
Maybe markets are smart not to panic. Adam Tooze, economic historian and professor at Columbia University, says the “geopolitical world” has cried wolf so much in recent years that investors have become inured to the doomsday howls, just as they have become de-sensitized to the unpredictable and erratic tendencies of Trump.
“We’re in a world of cognitive dissonance. There are two worlds. For the policy people, the world as we know it is really over. For folks in the markets, it’s continuity - you keep on trading,” Tooze told a panel at the Institute of International Finance conference in Washington on Wednesday.
Tooze calls it “escapism,” but this shouldn’t be confused with denial. Investors managing other people’s money have to make judgments and take positions every day. They can’t opt out. “There’s an underlying requirement to continue normal functioning in a world which is thoroughly abnormal,” Tooze told Reuters.
And there are real potential downsides, performance-wise, to reducing risk at a time when the geopolitical anguish isn’t yet showing up in corporate income statements. No asset manager wants to stand in front of a massive momentum trade.
The latest wave of optimism has some logical basis. It is mostly being fueled by the flood of U.S. first-quarter earnings, which are beating expectations, and consensus growth forecasts for the remaining three quarters of this year are moving higher.
Then there’s the hope or expectation that the ceasefire between the U.S. and Iran holds and turns into a wider, more lasting cessation of hostilities across the region. Investors are betting this leads to the Strait of Hormuz reopening, and a potentially sizeable fall in global oil and gas prices.
But this is where Tooze’s “escapism” arguably kicks in. The price of oil, gas, jet fuel and fertilizer will be significantly higher this year than investors thought on February 27 due to the long-term supply disruption from the bombing across the Middle East.
“Many market participants are not really coming to terms with the type of destruction that’s been wrought by this war,” said Helima Croft, managing director at RBC Capital Markets. “There’s no light switch.”
Middle East energy supply can’t be turned back on in an instant, and certainly not as fast as investors can turn off negative news.