Are Complacent Markets Masking the Rise of Geopolitical Risk?

Source: Thinkstock

Source: Thinkstock

If you look at recent price action in the stock market recently, you’ll see a steady uptrend as investors bid up stock prices. The bond market has been strong too, which keeps interest rates low making it easier for credit-worthy institutions to borrow money. Furthermore, the gold and oil markets have been subdued despite the fact that they are up for the year.

All of this indicates that the market doesn’t really care that there is rising political tension in Eastern Europe and in the Middle East. In just the past few days, we have seen flight MH17 crash (with the U.S. and Russia blaming one another and both assuming that it was an act of war), we have seen Israel invade Gaza, and we have seen a rocket fall just a mile from Ben Gurion International Airport in Tel Aviv, which led the FAA to suspend flights to Israel.

This is bad news, and it is scary that we are seeing these events follow one another as if this were a daily occurrence. But while these events are dominating the headlines markets, are relatively subdued. One would expect to see sharp movements in certain asset classes: stocks should be falling and gold and oil should be rising. Furthermore, volatility should be soaring.

The fact that we aren’t seeing this shouldn’t detract from the fact that geopolitical risk is rising, and with this in mind, I think investors need to prepare themselves before we do see these market moves. So what should you do?

First, I would consider taking profits in stocks. The stock market keeps rising even though earnings have been largely unimpressive and artificially inflated through record stock repurchase programs fueled by record low interest rates. As these stocks rise, it means investors are assuming a rosier outlook, which unfortunately conflicts with the fact that geopolitical tensions are rising.

Second, investors need to own some safe haven assets. I would avoid Treasuries, although there is no denying that the trend is higher. The reason is that rising geopolitical tension could spark selling from America’s creditor nations. It also means that America’s military budget can rise, which will increase supply.

On the other hand, gold is a safe haven you want to own going into a geopolitical crisis. While I am not convinced that the bottom is in for the gold market, we are certainly closer to a bottom than to a top, and the secular bull market in gold is far from over. Rising geopolitical tension could spark not just central bank buying and civilian buying, but it could spark additional rounds of quantitative easing, and this money can find its way into the gold market. Furthermore, we could see a revival of repatriation requests. For instance, Germany had requested that the New York Fed return its gold, and it suddenly backed off. A conflict involving the United States could force the Germans to demand that they get their gold back. If the Germans don’t get their gold it can spark rumors that the U. S. doesn’t have it, and this can spark further buying.

Finally, I think investors should buy oil. But how should you go about doing so? The first option is to buy an oil ETF that tracks the futures market. The best option is to buy one that tracks Brent Crude Oil, because this is the market supplied by the Middle East and Russia. The ETF for this is the United States Brent Oil Fund LP (BNO). Investors should also consider oil companies. But I would want to focus on companies with most, if not all operations in the United States and Canada. This will push you into smaller, more esoteric names, but these companies are very unlikely to experience production delays.

Ultimately, nobody likes war, but as investors we need to check our emotions at the door and look at the world rationally. Geopolitical tension is rising, and this has a real impact on asset prices. Thus, as an investor, you need to prepare yourself even if the market continues to be complacent. When market participants finally choose to recognize and react to these problems you won’t get any advanced warning, and so you should prepare now even if it means losing out on a few hundred Dow points.

Disclosure: Ben Kramer-Miller has no position in the funds mentioned in this article.

More From Wall St. Cheat Sheet: