Why do we use the word ‘sentiment’ so much when describing the reactions in the trading markets? Sentiment seems to be for romance novels and poems, but in the context of the markets it is widely used to describe the human emotional and adaptive responses towards events that impact on asset prices.
Negative sentiment is parallel to fear and gloom while positive sentiment compares to optimism and confidence. Another term that’s often seen in financial articles is: ‘investors shrugged off the news’. This relates to indifference, another human emotion or rather, in this context, the evaluation that the news is not significant enough to affect trading and investing decisions.
Geopolitical events affect supply and demand
The geopolitical causes of negative and positive sentiment are varied, but whether there will be a sustained reaction to such events boils down to a single question: will the cause present a significant risk towards the flow of supply and demand for the assets upon which financial instruments are based?
This is the big question that traders and investors have to answer for themselves when making their decisions under pressure. To use an example, a civil war breaks out in a country where gold is the main export. After the first shock of the news, gold traders have to evaluate whether the conflict will interfere with the supply of the precious metal used in jewelry making and manufacturing. Without gold, most of the electronics we’re so used to in our daily lives could not be manufactured. For this reason, gold traders and investors in gold mining stocks are careful to comb through news articles about the country and check analysts’ evaluations about the potential impact on the supply of gold.
If the news flow communicates increasing risks to gold supplies, traders and investors may begin to buy the various instruments used to trade gold in anticipation of the price rising due to limited supplies. Another scenario could be that the conflict dies down quickly and there are no risks to gold supplies, in which case sentiment could be wary but the reaction would not go as far as triggering a bullish trend in the gold markets.
This example is just one of the thousands of reactions ranging from minor to major happening in the markets each day. Supply and demand are based on the daily needs and wants of the global population, so there is a sharp focus on geopolitical news events which could have an impact on the vital arteries of commerce.
Research on geopolitical news and markets
The impact of geopolitical news on market sentiment is not only based on observing cause and effect in the everyday markets, but has also been confirmed and calculated by academic researchers.
The Geopolitical Risk (GPR) Index was developed by Dario Caldara and Matteo Iacoviello specifically to study the impact of geopolitical events on the financial markets. According to their research, 75 percent of market participants worry about geopolitical risk, and reactions in the markets are correlated with the frequency of news articles about adverse geopolitical developments from media outlets like newspapers.
Caldara and Iacoviello define geopolitical risk as “the threat, realization, and escalation of adverse events associated with wars, terrorism, and any tensions among states and political actors that affect the peaceful course of international relations.”
In practice, this definition can be expanded to include contentious elections, pandemics, changes in international trading deals, and events related to high-profile business leaders and politicians whose reach can and does influence the markets on an international basis.
Impact of geopolitical news on the markets
The GPR Index tracks market reactions to news events, for example, when the COVID-19 pandemic escalated, the index spiked from the level of 74 in December 2019 to the level of 138.42 in January 2020. At the time, supply-side risks shot up as countries shut down their borders and imposed travel restrictions to prevent the spread of the disease.
The GPR Index has an inverse correlation with market sentiment. The higher it goes, the lower market sentiment drops as investment, employment and stock returns come under pressure.
To conclude this article, newcomers to trading should be aware of the potential for sudden changes in sentiment due to geopolitical events, and practice good risk management accordingly.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
