ARE markets being foolishly sanguine about geopolitical risk?

At the end of July new economic sanctions against Russia did admittedly cause a sell-off across the markets and a flight to quality. Yet this was largely confined to Europe, where the main equity markets fell between 5pc and 9pc on average in response to Ukraine-related shock.

Both US and emerging market equities remained unbothered. And despite Russia’s importance as an east-west conduit for oil supplies, energy markets showed no sign of panic. Quite the opposite: spot oil prices fell about 11pc between the end of June and early September.

Only high yield credit markets suffered a global wobble. Even here market volatility was short lived. By early September it was business as normal — that is, prices back at historic highs and credit spreads close to historic lows. As the Bank for International Settlements puts it in its latest Quarterly Review, geopolitical worries were superseded by the anticipation of further monetary policy accommodation in the eurozone, providing support for asset prices.

Indeed, we are now in a world where investors appear ever more optimistic about what quantitative easing by the European Central Bank might deliver to the real economy, despite asset prices already being at high levels and the eurozone banking system being seriously underpowered.

There is the wider concern that stability and predictability, which provide the underpinnings of economic interdependence, will be undermined by geopolitics .... The free flow of capital, goods and services across boundaries would then be impaired

It is instructive, in looking at this seemingly Pollyanna-ish reaction to turbulence in Ukraine, Syria and Iraq, along with sabre-rattling by China in relation to Japan and other neighbours, to consider an earlier episode in the mid-1970s when markets suffered a much bigger blow in the face of geopolitical turmoil. In early October 1973 Egypt went to war with Israel.

Arab oil producers promptly declared economic war on the developed world by proposing to double the oil price. Despite the potential impact on the cost of the advanced countries’ oil imports, equity markets remained curiously insouciant for three weeks after the news. Then on November 9 1973, Wall Street was hit by one of its biggest ever one-day falls. London immediately plunged. Between November 9 and December 14 the FT All Share Index fell 2pc .

The first point of difference, when making comparisons with today, is that the world economy at that time was in the throes of a synchronised boom, fuelled by excessive monetary expansion. Inflationary pressures were exacerbated by high wage demands by heavily unionised labour. So when excess demand confronted constrained energy supply the consequences for the world economy and for global inflation were lethal.

Today there is a genuine short-term energy supply concern for Europe. But it is being offset by demand factors in the eurozone. German-led austerity and the ECB’s extraordinarily slow response in the face of imminent Japanification ensure that the eurozone suffers from a severe lack of demand. Inflation is simply not a problem for the foreseeable future. So the markets’ untroubled view of geopolitics is understandable. The question is what could make this look unduly complacent.

The first and most obvious answer is an escalation of the conflict in Ukraine, followed by further sanctions and a seizure in capital flows and cross-border bank lending. It would take very little to tilt Europe into full scale recession. That, in turn, could prove contagious for the rest of the world. Over the longer term there is also the risk of terrorist activity in the west sparked off by Isis (the Islamic State of Iraq and the Levant) or other disaffected Arab groups, leading to physical disruption of markets and damage to payments and settlement systems.

Then there is the wider concern that stability and predictability, which provide the underpinnings of economic interdependence, will be undermined by geopolitics, raising the risk that confidence in the infrastructure of globalisation will erode. The free flow of capital, goods and services across boundaries would then be impaired.

The difficulty for investors, of course, is that these are not things that can be readily quantified or modelled. But given the current fragility of the global recovery it is remarkable how wide-eyed faith in the power and wisdom of central bankers has so thoroughly dispelled concern about geopolitical ructions. It is as if we are in the financial equivalent of a phoney war.

The writer is an FT columnist

Published in Dawn, Economic & Business, September 22nd, 2014