The S&P 500 made a new high last week, finally closing over the 1900 level. European stocks were also higher on the week and have continued the rally Monday, even after election results over the weekend showed an uncomfortable gain for some parties that are, well-- let's just say that some of their ideas are not exactly in keeping with the EU mantra of togetherness.
Japanese stocks, most of the rest of Asia and emerging markets also managed to post gains. In bond land, Treasuries held their own despite somewhat better economic reports in the U.S. (more on that later), high yield bonds barely budged and the market favorite for higher rates, bank loans, enjoyed another good week as well. The dollar also had a decent week with the trade weighted index back above 80 as the Euro weakens in anticipation of ECB QE.
What wasn't up last week and hasn't been for a long time now is volatility. That shouldn't be much of a surprise with the world's central banks so active. Volatility is essentially the inverse of liquidity and as long as it is ample, volatility will remain depressed. What is so eerie about the lack of volatility right now though is that it isn't confined to stocks. Basically, all asset classes are going through a period of low - and in many cases declining - volatility. Currencies have been extremely well behaved since the minor disruption in emerging market currencies last year. Bonds of all kinds have been acting so sedately that one would think that junk bonds trading at such skinny spreads are just normal and expected to continue forever. Even commodities, where traders have always gravitated in search of volatility they can trade, have been moving at a snail's pace. Gold has been trading in a roughly $50 range since mid-April that matches the trend in inflation expectations (as expressed in the TIPS market). The oil market is stuck in a similar purgatory, trading in an $8 range since the beginning of March.
Normally I would take this as evidence of complacency, something I generally don't like in my markets since it is so often followed by sheer terror. But I think this is something different than previous periods of quiet. The recent nearly complete lack of volatility is, I think, a product of a very confusing environment. It isn't that investors are complacent about risk but rather more that they are paralyzed into inaction as they wait on more information about the economy and other factors. We can see this in the AAII weekly sentiment poll where the largest contingent resides in the Neutral camp at 43.2% of the respondents. That is 13% higher than the long term average, while the bull and bear camps are both less than their long term averages. We also see it in the volume statistics for a range of assets from stocks to forex to commodities.
Markets today face a range of uncertainties the outcome of which could have pretty dramatic consequences for global economies and markets. The situation in Ukraine has gotten a lot of press and is cited frequently as a factor in daily market movements but it is far from the only geopolitical concern. In fact, I don't think Russia's moves in the Crimea or even potentially greater Ukraine will be seen by history as consequential at all. On the other hand, I suspect that China's moves in southeast Asia - specifically the South China Sea - will be seen in retrospect as a paradigm shift in the geopolitical balance of power. Russia and China appear to be positioning themselves to be the dominant powers in Asia for a long time to come.
China is in the midst of a military makeover that has its roots in energy, economic and political insecurity. Their moves in the South China Sea against Vietnam, the Philippines and Japan have gone largely unnoticed by the western public but certainly not in Asia. The Chinese have been strengthening their Navy for several years and there is more to come as they seek to control the energy rich area off their southern coast. China will increase military spending this year by 12% and I suspect this has as much to do with the trajectory of their economy as it does their geopolitical ambitions. The economy boomed for years through massive investment in housing, infrastructure and export capacity. Now that those areas are showing signs of diminishing returns the Chinese leadership is searching for a new source of growth and it appears they have settled on the military as the new outlet of their investment urge. Happily for them, it addresses their concerns about jobs and the civilian unrest that might induce while also supporting their power and energy ambitions in Asia. China's military budget is now the second largest in the world - behind the U.S. - and about 2.5% of GDP (about 4.5% in the U.S.). If non military growth stumbles further, expect that number to rise.
The recent natural gas deal between Russia and China furthers the isolation of the U.S. in Asia. Russia needed to find new markets outside Europe and more importantly outside the U.S. dollar (the deal will be settled in Rubles and Yuan). China needed a reliable long term source of energy, but more importantly, the deal turns Russia from a potential enemy to their north into an ally. Much of China's military planning in the past has focused on Russia or previously the Soviet Union as a potential threat. Now, with Russia reliant to some degree on Chinese capital and energy demand, that threat has been removed. Putin is unlikely to do anything that would upset his Chinese customers and that leaves China free to concentrate on its southwestern border, much to the chagrin of countries like Vietnam.
I can't begin to fathom the long term consequences of the increased cooperation between Russia and China or China's increasingly muscular military moves in southeast Asia. It does appear though that the world is splitting along familiar lines once again with China the dominant player in Asia, Russia with a stranglehold on Europe (through energy supply this time rather than ballistic missiles) and the U.S. struggling to maintain influence in Latin America and the Middle East.
Call it a new cold war or whatever you want but the fact is that China and Russia are on the advance while the U.S. sphere of influence is shrinking. Given our economic challenges, a reversal of that trend seems unlikely in the short or even medium term. Some might think that isn't a bad thing and it may not be, but it certainly changes the geopolitical risk profile for a global investor. If nothing else, with China's moves in the South China Sea, the odds of an "incident" that turns into actual military conflict have risen dramatically.
As for our economic challenges, that too is a large source of uncertainty for investors. We have yet to see definitive evidence that the U.S. economy is either continuing on its recent weak course or if the perennially optimistic economic forecasters will get one right for a change. The economic data each week has something to comfort the bears and the bulls. Last week was no exception. Housing bulls were cheered by an increase in existing and new home sales while the bears could point to another drop in purchase mortgage applications. Bulls got a rise in the PMI flash index while bears eyed a Chicago National Activity Index that showed a sharp deceleration in April. Bulls saw an increase in the LEI as confirming while bears pointed to weekly jobless claims that jumped a large 28k on the week. And so it goes with no resolution for either camp.
The same can be said about Europe, where the dominant market theme right now is waiting on the ECB to implement QE, something I think will require more patience than most expect. The ECB may cut interest rates at their next meeting but QE is likely not coming for some time, if at all. Meanwhile, the European economy continues its slow - very slow - restructuring and growth is scarce.
One thing of which I'm fairly certain is that when volatility does make an appearance, it is likely to be dramatic. We've been through these periods of low volatility before and they are usually followed by an extreme example of the opposite. Of course, this could go on for some time before markets return to their volatile ways. The stock market's volatility gauge traded in a similar range for almost all of the period from 2005 to 2007. That was another period of extreme liquidity and we all know how that one ended. With the world's central banks concentrating on nothing but liquidity provision for years now in a most unprecedented way, I think it is highly unlikely that they can remove it in any significant way without a major market disruption. Are we coming to another Minsky moment?