Why Haven’t Rising Geopolitical Risks Roiled The Equity Markets? (SPY)

From Invesco: Geopolitical risk has risen in many areas of the world, and we saw several key issues escalate last week. When I travel and meet with clients, I’m increasingly asked why markets don’t reflect these growing risks.

Part of the answer is that markets have simply become somewhat immune to it. However, I also believe that two key factors have helped cushion capital markets from the impact of geopolitical risk: accommodative monetary policy and the growing global economy. In this week’s commentary, I discuss all of these competing market forces.

Geopolitical issues worsen

North Korea. First and foremost, the situation in North Korea continues to escalate. Last week, a North Korean spokesperson said that warnings of a possible nuclear test over the Pacific Ocean should be taken literally. Then Japan’s defense minister announced that the threat from North Korea had reached a “critical and imminent level.” Over the past weekend, US Secretary of Defense James Mattis, fresh from a visit to South Korea, warned that the threat of a nuclear attack by North Korea has increased, which has brought a “new urgency” to cooperation between the US and South Korea and other allies.

Mattis made it clear that diplomacy remains the “preferred course of action.” However, he also made it clear that the US is committed to defending itself and its allies from North Korean aggression, explaining that, “Any use of nuclear weapons by the North will be met with a massive military response, effective and overwhelming.” It seems that Mattis’ comments were directed at China — while the US, South Korea and Japan have increased their sanctions on North Korea, they believe they have not been as effective because they believe China continues to quietly allow some trade with North Korea. The preferred course of action, diplomacy, hinges on China’s cooperation. With US President Donald Trump visiting Asia this week, I would expect a “carrot and stick” approach to winning China’s support for increased sanctions — and adherence to those sanctions — against North Korea by threatening trade protectionism while offering enormous praise for Chinese President Xi Jinping’s growing political strength and consolidation of power.

Spain. The situation turned from bad to worse in Spain last week, as Spanish Prime Minister Mariano Rajoy spurned Catalonia’s request to negotiate the terms of greater independence. In response, Catalonia — which up until then seemed reluctant to attempt an actual secession — voted to establish an independent government. This in turn was met with Rajoy’s dissolution of the Catalonian parliament. We may soon see more disruption, as Spain attempts to enforce direct rule and replace Catalonian officials with pro-Spanish unity administration officials. However, markets have shrugged this off — the yield on the 10-year Spanish government bond rose, but then fell back. Spanish stocks, as represented by the Spanish IBEX 35 Index, have actually risen in recent days.

United Kingdom. In the UK, Prime Minister Theresa May continues to experience difficulty in negotiating the terms of departure from the European Union (EU). Her recent difficulties, however, have come from within the UK. Both Scotland and Ireland have expressed concern over the limited progress made in negotiations thus far, and are worried that she will not be able to secure a deal in a timely fashion. Scottish Prime Minister Nicola Sturgeon has asked May for confirmation that a transition agreement with the EU will be reached by the end of this year — Sturgeon reportedly told May that she was increasingly concerned Brexit talks would end in no deal.

However, May is also receiving significant pressure from major Tory donors to leave the EU without a deal if she cannot reach favorable terms in Brexit negotiations. They point to the difficult situation the UK is in — being forced to agree on a “divorce bill” before making a trade agreement, which removes the UK’s ability to use the money as a bargaining chip with regards to trade. It seems that the number of potential outcomes for the UK has expanded; in other words, all bets are off.

United States. Charges were filed today in the Trump-Russia probe. Some have suggested this could jeopardize the US tax reform bill, although I believe that is unlikely. After all, many members of the US Congress are eager to produce a tax reform bill so that they may return to their constituents by next spring with an important accomplishment under their belts.

Monetary policy and economic growth are helping markets shrug off geopolitical risk

As I mentioned above, geopolitical risk is nothing new for markets, which often respond with a short-term reaction or no reaction at all. However, I also believe accommodative monetary policy and the growing global economy are helping provide a cushion.

Monetary policy. While geopolitical risk is rising, monetary policy risk appears to be moving lower. That’s because major central banks are expected to remain somewhat more “dovish” — in other words, more likely to maintain the status quo. In the US, Trump is expected to nominate a new Fed chair this week, and speculation points to Jerome Powell, who joined the Fed Board of Governors during the Obama administration. As I’ve mentioned in previous commentaries, Powell is ideologically similar to current Fed Chair Janet Yellen, and is therefore most likely to maintain the status quo. If he is appointed, it will be a relief, as it means less likelihood of a policy error caused by more rapid “normalization.”

This is also true for the European Central Bank (ECB). Last week, as expected, ECB President Mario Draghi announced the start of tapering. However, the details of the plan aren’t exactly what observers were anticipating. Draghi announced that ECB bond buying would be cut in half starting in January — but that it would continue for a longer time period, until at least September 2018. This in turn suggests that a rate hike will take even longer, given that the ECB has previously suggested rate hikes will only occur well after the ECB asset purchase plan has ended. The idea of a more gradual normalization process should provide some solace to European markets in the face of growing geopolitical turmoil.

A similar scenario is likely in Japan. With Prime Minister Shinzo Abe’s success in the snap elections last week, not only is there a mandate for a continuation of his administration’s fiscal policies, but also its monetary policies. That means the Bank of Japan can continue to pursue its current path of highly accommodative monetary policy.

All of this suggests more accommodative monetary policy from the world’s major central banks — in other words, rates should be lower for longer. In particular, this reduces the threat that balance sheet normalization will be disruptive to the economy, given that it now appears that the process will be very slow and gradual. My two takeaways from this are that 1) emerging markets should benefit from a more dovish monetary climate; and 2) the hunt for income continues in an environment with lower rates.

Economic growth. We got more signs of improvement in the global economy last week, with the Commerce Department’s initial estimate for US gross domestic product (GDP) growth in the third quarter clocking in at 3% annualized. Also last week, GDP growth for South Korea was released, indicating 1.4% growth — the fastest quarterly growth in seven years. We also saw the Ifo Business Climate Index for Germany hit an all-time high in October. French business confidence has also risen again, and Japan has actually experienced six consecutive quarters of economic growth — the longest stretch since 2006.

Investing in a volatile worldKey takeaway

In summary, monetary policy can’t shield countries from nuclear weapons, but it can soothe markets. While improving global growth can’t stop secessionist movements, it may improve investor sentiment. And so, at least for the time being, geopolitical risk may not cause markets to shudder. However, we will want to follow the situation closely. In particular, I worry about the vulnerability of the US stock market despite a good earnings season thus far and low volatility indicated by the VIX Index. One reason to be wary is that the Investors Intelligence Survey, widely considered a contrarian indicator, has now registered above the critical 60 level for bullishness for three consecutive weeks. As with every indicator, it is not foolproof, but it does suggest more caution and discernment in choosing investments. It is a reminder that, while investors with longer time horizons typically need capital appreciation, they need to keep in mind the importance of downside protection.

Looking ahead

Expect an action-packed week, with earnings reports in full swing and a slew of central bank meetings — the Bank of Japan, the US Federal Open Market Committee and the Bank of England. The Bank of England’s meeting is particularly important because many expect it to raise rates for the first time in a decade at this meeting. Also on the docket is a possible Fed chair announcement and US non-farm payrolls, among other important data points.

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Important information

Blog header image: Bacho/Shutterstock.com

The Ifo Business Climate Index is a highly regarded early indicator of economic developments in Germany published on a monthly basis.

The IBEX 35 Index is composed of the 35 most liquid stocks traded on the Spanish Continuous Market.

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 Investors Intelligence Survey (US Advisors’ Sentiment Report) surveys more than 100 independent market newsletters to assess the percentage of bulls versus bears.

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Alternative products typically hold more nontraditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate. You can lose money.

Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

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The opinions referenced above are those of Kristina Hooper as of Oct. 30, 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.

The SPDR S&P 500 ETF Trust (SPY) rose $0.43 (+0.17%) in premarket trading Tuesday. Year-to-date, SPY has gained 15.92%.

SPY currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #1 of 125 ETFs in the Large Cap Blend ETFs category.

This article is brought to you courtesy of Invesco.