The End of Teflon Markets?

Markets shrugged off increasing geopolitical tensions for months, but lately investors seem more sensitive to flare-ups in Ukraine and the Middle East.

U.S. stock markets sailed through Russia’s March annexation of Ukraine’s Crimean peninsula and months of tit-for-tat sanctions between Moscow and the West. The Dow Jones industrial average gained more than 300 points that month. When Islamist militants started capturing key Iraqi cities in June, threatening the integrity of Iraq, markets continued to climb steadily. By the end of June, the Dow had gained 500 points since the beginning of the year.

Now, over the past few weeks, markets suddenly seem to be jumpy. Since the middle of July, when Israel invaded Gaza, adding another hot spot to potential investor concerns, the Dow has dropped about 500 points, trimming most of its gains from this year. After an uptick on Monday, Aug. 11, U.S. stock markets wavered Tuesday morning on news that dashed hopes of greater political stability in Ukraine and Iraq. Are the markets newly sensitive to a whole host of international crises?

The standoff between Russia and the West over Ukraine has perhaps the biggest potential to damage the global economy, and a new potential flash point took shape this week. Although Moscow, Kiev, and the Red Cross agreed on Monday to coordinate aid for eastern Ukraine, by Tuesday the arrangement seemed to further rattle, rather than calm, nervous investors. Trucks supposedly carrying Russian humanitarian aid rumbled toward the border with Ukraine Tuesday morning, even though Kiev said it will only accept supplies crossing the border in Red Cross trucks.

Developments in Iraq also gave investors reason for pause. Prime Minister Nouri al-Maliki refuses to cede his position to a newly appointed successor. His obstinacy threatens a government transition that Barack Obama’s administration hails as a step forward for the country that is trying to fight a powerful militant insurgency.

Douglas Rediker, a visiting fellow at the Peterson Institute for International Economics and a former IMF executive board member, said markets have been "remarkably sanguine over broad geopolitical risk" until recently. Oil markets are being remarkably impervious to bad news out of the Middle East. The International Energy Agency said Tuesday in its monthly report that increases in production from North America mean there is plenty of oil to go around, despite conflicts in oil-producing countries such as Iraq and Libya.

But it’s too early to say whether U.S. stock markets have developed a new sensitivity to bad international news or will continue their ho-hum progress after this latest dip.

Powerful counterforces are pushing markets up, most importantly the easy-money policies of the U.S. Federal Reserve. After holding U.S. interest rates low for so long, driving down returns on safe investments such as Treasury bonds, investors are looking far and wide for assets that will deliver returns, no matter how risky.

"People have become probably a little bit complacent about the risks that are out there, but they don’t have many other options for their portfolio," said Robert Johnson, director of economic analysis at investment research firm Morningstar.

Without a lot of safe options, investors become less sensitive to risks of all sorts, whether financial or political.

Johnson said the market is much more sensitive to announcements from the Fed about when it will start raising interest rates than the various crises around the globe. He said the markets similarly were unfazed by the Arab Spring and the upheaval in Libya.

"What’s happening is we’ve had so many of these events happen over the past three of four years that traders are getting a little numb to them," Johnson said.

If the Fed were to change policy, geopolitical risks could become more of a concern for investors, but until then, it’s unclear whether bad headlines are enough to dampen investors’ enthusiasm over the long term.

"On one side you’ve got central bankers’ expansionary monetary policy creating exceptionally low volatility, and on the other hand you’ve got a series of geopolitical hot spots that are escalating as a trend, and the question is, which one is going to win out?" Rediker said.