Why do we use the word “sentiment” so much when we describe the reactions in the trading markets? Sentiment seems to be for romance novels and poems, but in the context of the markets is widely used to describe the human emotional and adaptive responses to events that affect asset prices.
A negative feeling is parallel to fear and sadness while a positive feeling is compared to optimism and faith. Another term that is often seen in financial articles is: “investors took the news away”. This refers to indifference, another human emotion or rather, in this context, the assessment that the news is not significant enough to influence business and investment decisions.
Geopolitical events affect supply and demand
The geopolitical causes of negative and positive sentiment are diverse, but will there be a lasting reaction to such events boil down to a single question: will the cause present a significant risk to the flow of supply and demand for the assets on which financial instruments? are based?
This is the big question that traders and investors must 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 initial shock of the news, gold traders must assess whether the conflict will hinder the supply of the precious metal used in jewelry and manufacturing. Without gold, most of the electronics we are so used to in our daily lives could not be manufactured. Therefore, gold traders and investors in gold mining stocks are careful to comb through news articles about the country and check analysts’ estimates of the possible impact on the supply of gold.
If the news feed communicates increasing risks to gold supplies, traders and investors may start buying the various instruments used to trade gold in anticipation of the price rise due to limited supplies. Another scenario could be that the conflict subsides quickly and there are no risks to gold stocks, in which case sentiment could be cautious, but the reaction will 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 every 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 that could affect the vital arteries of trade.
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 daily 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 are worried about geopolitical risk, and reactions in the markets correlate with the frequency of news articles about adverse geopolitical developments from mass media such as newspapers.
Caldara and Iacoviello define geopolitical risk as “the threat, realization and escalation of adverse events associated with wars, terrorism, and any tensions between 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 trade agreements, and events related to high-profile business leaders and politicians whose outreach can and does affect 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 surged from the level of 74 in December 2019 to the level of 138.42 in January 2020. At that time, supply-side risks shot up. up as countries closed 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 falls, as investment, employment and stock returns depress.
To conclude this article, newbies 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 considered as containing investment advice, investment recommendations, an offer or solicitation for any transactions in financial instruments. Please note that such business analysis is not a reliable indicator of 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 involved.
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