As the globe watches North Korea, US stocks prove vulnerable to rumors
By Kristina Hooper, Global Market Strategist. Posted on Expert Investment Views: Invesco US Blog.
Global stocks were relatively flat last week. However, US stocks fell for the second week in a row.1 Fear was in the air for US capital markets, with the VIX volatility index up and the US 10-year Treasury yield still low. The standout last week was emerging market stocks.
After a short respite, tensions with North Korea resume
Taking pressure off stocks globally was an easing of tensions between North Korea and the US, as North Korean dictator Kim Jong Un appeared to back down after a war of words the previous week. However, this calm was short-lived. That's because North Korea is very concerned about the annual US and South Korea war games that are planned to begin this week on the Korean Peninsula. Other nations have asked the US and South Korea to postpone or dramatically alter their exercises this year in light of recent tensions and concerns that the drills increase the potential for a mistake and/or misinterpretation that could set off a regrettable chain of events. However, the Ulchi Freedom Guardian military exercises will go ahead as planned.
The drills, which reportedly involve more than 15,000 US troops and more than 50,000 South Korean troops, are intended to improve joint decision-making and planning between the two countries and improve overall readiness. As with all military exercises, there is an element of muscle flexing that goes along with them. The decision to proceed with the military drills led North Korea to resume its rhetoric on Sunday night, warning that the war exercise "is a reckless behavior driving the situation in to the uncontrollable phase of a nuclear war." It threatened a "merciless strike" on the US. The situation was likely complicated by last week's published interview with former White House strategist Steve Bannon. The interview may have hampered the US' ability to negotiate with strength against North Korea given Mr. Bannon's assertion that there are no military options available to the US, which in turn suggested that President Donald Trump's rhetoric last week regarding military action against North Korea was toothless. So this week could see a resumption of pressure on stocks globally.
US stocks appear vulnerable
In the US, stocks were weighed down in the aftermath of the tragic events in Charlottesville, Virginia - specifically, rumors that Gary Cohn, the Director of the National Economic Council, would resign. Mr. Cohn is viewed as critical to the passage of tax reform legislation; hence the negative reaction to the resignation rumors, which subsequently were denied. The market's behavior last week supports my view that US stocks have been priced with expectations of "legislative perfection" - the assumption that the president's legislative agenda in its entirety would become reality - and that they are therefore vulnerable.
On the other side of the coin, it seems that US stocks got some support from the release last week of the minutes from the July Federal Open Market Committee (FOMC) meeting. The minutes showed that the US Federal Reserve (Fed) may be a bit more reluctant to raise rates because of the recent spate of low inflation. There is growing concern that inflation is not as transitory as originally presumed. According to the FOMC minutes: "Many participants … saw some likelihood that inflation might remain below 2% for longer than they currently expected" and several even indicated that "the risks to the inflation outlook could be tilted to the downside." Having said that, the FOMC seems ready to begin balance sheet normalization and seems complacent about Fed Chair Janet Yellen's view that this can "operate in the background" while the Fed focuses on its primary monetary policy tool: the fed funds rate. And, of course, given the Fed's data-dependent focus with regard to monetary policy, we could still see a rate hike by year end. It all depends on what the economic data look like this fall.
The minutes from the most recent European Central Bank (ECB) meeting were also released last week. They indicate concern about a strongly appreciating currency. With a strong euro and inflation low, the ECB will likely try to talk down the euro - and may be thinking twice about reducing accommodation. It seems that, when they do announce their plan for tapering, it will follow the Fed's in terms of being very delicate and ever so careful.
It is worth noting that, in its minutes, the FOMC again raised concerns about US stock market valuations: "Since the April assessment, vulnerabilities associated with asset valuation pressures had edged up from notable to elevated, as asset prices remained high or climbed further, risk spreads narrowed, and expected and actual volatility remained muted in a range of financial markets." This also supports my view that stocks are priced for legislative perfection.
The reality is that the US stocks could continue to perform well for a while, as there are a number of factors - not the least of which is accommodative monetary policy - to support the market. However, I believe that a comparison of the US stock market with eurozone stocks and emerging market stocks argues for greater exposure to the latter two as there is arguably greater upside potential.
- Eurozone stocks could benefit from the improving macroeconomic environment. Just last week it was reported that the eurozone economy accelerated to 2.5% year-on-year growth annualized for the second quarter.2
- Emerging market stocks are also very attractive, with lower valuations, higher growth levels and the potential for reform in some key economies. For example, in the International Monetary Fund (NYSE:IMF) growth forecasts (as of July 2017), gross domestic product (GDP) growth for advanced economies is expected to rise to 2% in 2017, while GDP growth for emerging economies is expected to rise to 4.6%. For 2018, GDP growth is expected to be 1.9% for advanced economies and 4.8% for emerging economies. In addition, valuations are generally more attractive for emerging economies than for developed ones: The MSCI Emerging Markets Index currently has a forward price-to-earnings (P/E) ratio of 12.53. That compares with 14.81 for the MSCI EAFE Index and 18.04 for the S&P 500 Index (as of July 31, 2017).3
There is so much for investors to pay attention to. Perhaps most important, in my view, is the Kansas City Fed conference at Jackson Hole. Some famous speeches have been delivered at Jackson Hole over the years, with a few central bank leaders revealing their ideas and plans for the future. However, given that the most recent ECB minutes indicate a desire to communicate very carefully and thoughtfully, we are unlikely to get any big revelations from ECB head Mario Draghi. However, we may get more insights into balance sheet normalization from Fed Chair Yellen despite the fact that the topic of her speech will be financial stability.
We will also want to pay attention to the position papers that the UK government is expected to release as part of its Brexit negotiations. There is a growing chorus of criticism regarding the UK's approach to the talks. We will need to get used to continued uncertainty as part and parcel of the ongoing Brexit negotiations. Similarly, we will want to watch the North American Free Trade Agreement (NAFTA) re-negotiation talks between Canada, Mexico and the US, which began with a rocky start last week. I believe de-globalization is one of the biggest threats to the largely rosy global growth picture.
- Global stocks based on the MSCI All Country World Index. US stocks based on the S&P 500 Index.
- Source: Eurostat
- Sources: MSCI and Standard & Poor's
Blog header image: f11photo/Shutterstock.com
Forward price-to-earnings ratio is calculated by dividing a company's current share price by its expected earnings, usually for the next 12 months or next full fiscal year.
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 (NASDAQ:CBOE) Volatility Index, which shows the market's expectation of 30-day volatility.
The MSCI All Country World Index is an unmanaged index considered representative of large- and mid-cap stocks across developed and emerging markets, excluding the US.
The S&P 500® Index is an unmanaged index considered representative of the US stock market.
The MSCI EAFE Index is an unmanaged index considered representative of stocks of Europe, Australasia and the Far East.
The MSCI Emerging Markets Index is an unmanaged index considered representative of stocks of developing countries.
The opinions referenced above are those of Kristina Hooper as of Aug. 21, 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 information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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Weekly Market Review: Pressures mount on equity markets by Invesco US