Last week we experienced greater geopolitical uncertainty involving the US:
- The US bombed Syria, which in turn resulted in a deterioration in American relations with Russia.
- The US sent warships off the coast of North Korea and implored China to take a tougher stance on the country, offering trade incentives.
- The US dropped its largest non-nuclear bomb on ISIS in Afghanistan.
Adding to the uncertainty is that the above actions came as a surprise to many who expected the Trump administration to take an isolationist stance on world affairs. These actions raise other concerns as well.
Uncertainty breeds concern in the US
First, there’s concern that the country may become mired in military conflicts, which are not only tragic but can dampen sentiment and place pressure on the federal budget. The Congressional Budget Office already predicts a significant increase in the deficit by 2018, given President Donald Trump’s plans; that could worsen in the event of lasting military aggression in either Syria or Afghanistan — or both. These are conflicts that we might not lose but might not be able to win either, draining resources and military attention for years to come (consider one of candidate Trump’s greatest criticisms of the Bush Administration: Iraq). And, of course, the greatest fear would be military conflict with North Korea, given their cache of weapons and a leader whose actions are difficult to predict.
Second and more immediate, there’s concern about the uncertainty and downright fear this creates for US capital markets. We saw a glimpse of it last week. Not only did stocks fall on the week, but the 10-year Treasury rallied, as did gold. In fact, the yield on the 10-year Treasury is at the lowest level it has seen since November — and we can’t ignore what that is telling us. Treasuries are seen as a “safe haven” — an asset class to rely on when geopolitical concerns increase. Similarly, the other perceived safe haven in times of great uncertainty — gold — has rallied in the past few months, also indicating that risks are increasing. In fact, the Credit Suisse “Fear Barometer,” which measures the cost of protection against a market crash, is at the highest level it has been at since right before the Brexit vote last year. Finally, the VIX, which measures the volatility of the S&P 500 Index and is viewed as an indicator of fear in the stock market, is at its highest level since November.
Questions about ‘Frexit’ and a US government shutdown
What’s more, recent polling suggests greater uncertainty about the outcome of the French election, the results of which could lead to a “Frexit” referendum. This in turn could lead to greater disruption for the European Union as it tries to manage the exit of the United Kingdom.
We also have some risks closer to home in the coming weeks. The US is heading toward a possible government shutdown if Congress doesn’t pass a continuing spending resolution at the end of April. Currently, the likelihood of a government shutdown seems small. However, given Congress’ failure to pass health care legislation to replace the Affordable Care Act, investors can’t take passage of the continuing resolution for granted. And don’t forget we then have to worry about Congress agreeing to raise the debt ceiling, which should occur sometime this summer.
So the list of risks goes on and on. It seems to me that US capital markets are finally starting to reflect more realistic expectations for the future rather than a very best case scenario. In this environment, I believe caution makes sense — particularly for those investors with shorter time horizons. That could include exposure to stocks with lower valuations and lower volatility, to gold, and to other alternatives that have not historically been closely correlated with equities.
The iShares S&P 500 Index ETF (NYSE:IVV) was trading at $235.38 per share on Monday afternoon, up $1.35 (+0.58%). Year-to-date, IVV has gained 4.62%, versus a 4.64% rise in the benchmark S&P 500 index during the same period.
Blog header image: zhu difeng/Shutterstock.com
All investing involves risk, including risk of loss.
The Credit Suisse Fear Barometer (CSFB) is calculated by selling a 10% out-of-the-money call on the S&P 500 Index and using that premium to purchase downside protection. The level of the index indicates the percentage strike price out of the money for the put is needed to make the strategy net zero cost. A high CSFB reading signals high cost of protection relative to upside calls.
The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility.
The opinions referenced above are those of Kristina Hooper as of April 17, 2017. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
This article is brought to you courtesy of Invesco.