Too many capital market participants seem fixated on anticipating that good times lay just around the corner despite all evidence in recent years to the contrary. The muted bond market reaction to the escalating crisis in Israel’s is the driver of the latest demonstration of this Pollyannaish approach.
The long end of Israel’s curve was down only three points on Monday as the country retaliated against Hamas’s violent incursion over the weekend. Other Middle Eastern credits that might be affected lost less than a point. On Tuesday there was a rally even as the conflict escalated and casualties began to be counted in the thousands.
Certainly, previous episodes of conflict between the Palestinans and Israel have been somewhat short-lived. But the weekend attacks were notably larger in scale and have clear ramifications for the region and the potential to involve neighbouring states and other regional powers.
Despite that, the oil price at its worst was up about 5% as investors said a number closer to 25% would be more indicative of expected disaster. They said, in essence, that this conflict was already old news, so why should they sell now?
The reaction to this week’s situation in Israel and the Gaza Strip was markedly different to when Russia invaded Ukraine last year, when US sanctions and a mass international investor freeze out of Russia sent bond prices across the CEE plummeting and oil prices soaring.
In part this is because of the countries’ relative importance to the global economy. Russia is a big fish with control over energy and oil, metals, uranium and gold. Israel is much smaller and the effect of a war there initially seems much less impactful in global economic terms.
The response this week is closer to what happened when Russia annexed Crimea in 2014. Then followed a small sell-off and nine years of generalised concern for Ukraine that worse might come but the market turned a blind eye to the looming risks and most investors continued to buy unsanctioned Russian, which they then took huge losses on in 2022.
All out war in the Middle East may not follow next week, or even next month, but the lessons of Crimea are surely clear for investors.
This willingness to assume a benign outcome has been a feature of markets in recent years. Inflation was broadly believed to be transitory in the wake of the Covid pandemic. It has proved anything but.
Then, as central banks raised interest rates to fight it time after time, there was a palpable sense that many believed peak rates to be just around the corner, with cuts to follow soon after. Believers in that narrative have been beating that drum for almost as long as central banks have been tightening policy, which shows no sign of abating.
What justifies such persistent bullishness? One explanation is that no one believes in the bullish case at all but that in markets it is more important to guess correctly what everyone else believes. And so, once the prevailing mood turns positive, it becomes self-fulfilling. Certainly, one is less likely to lose one's job when the whole herd ends up stranded rather than being the lone stray sheep.
Also, investors are biased towards finding reasons to buy stuff rather than just leaving cash under the mattress. They cannot charge fees for not putting people's money to work, after all.
Then there's the lesson that has been taught repeatedly since 2008 - that when a crisis is big enough, the developed world's central banks will step in so nobody loses too much money.
And finally, investors in emerging markets by their very nature are a less risk averse bunch. This has never been the asset class to play in if you want Steady Eddie returns.
But crises are so because they happen faster than people can react to them in ways they do not anticipate and there is plenty so far to suggest that the markets, on the whole, are being rather gung ho about how this latest flashpoint in the Middle East could develop.