Geopolitical events have taken a harsh turn this summer: a return to the Dark Ages in parts of Syria and northern Iraq by the forces of ISIS; Putin & Co.’s new Cold War; and the hemorrhagic fever outbreak gripping west Africa with deadly alacrity. These all have coalesced to remind us, in case we forgot, that the world is a dangerous place.
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Despite the troubling actions of the last several months, global equity markets have remained remarkably nonplussed. Since the end of May, the MSCI World Index advanced 2.52%. Prices within the fixed income complex also marched higher, with the Barclays Global Aggregate Total Return Index gaining 0.21%.1 Capital markets in the US were robust this summer, as the S&P 500 and the Barclays US Aggregate indexes advanced 4.68% and 0.90%, respectively.
Embracing and eschewing risk
Growth in the American economy is gathering pace. The weather-related contraction in the first quarter did not spill over into the second quarter as some had feared. The recently revised second-quarter GDP report to 4.2% from 4.0% suggests investors should enjoy continued growth momentum. Indeed, they were quick to capitalise on the rising tide by pushing up both small and large company share prices, with the Russell 1000 and 2500 indexes gaining 4.78% and 4.55%, respectively.2
Euro zone equities struggled during the period, declining 5.37% in dollar terms, as investors’ fears focused on the deflationary pull of internal devaluations and the fragile state of the currency bloc’s nascent recovery. Anticipating the latest edition of monetary medicine from the European Central Bank (ECB), euro zone sovereign yields have shrunk. The benchmark 10-year bund declined from 1.93% at the end of 2013 to 0.93% at the end of August. Shrinking interest rates in the euro zone and Russian irredentism are making themselves felt on the other side of the Atlantic.
Normally, robust economic activity causes investors to exit longer duration fixed income securities. Yet, despite rising employment, a central bank openly rethinking the timing of interest rate hikes, and the imminent conclusion of what has been “industrial quantitative easing”, the yield on the 10-year Treasury continues to decline. This drop appears to be driven both by interest rate differentials between Europe and the US and fears about the geographic fracture of the Ukraine. Consider the relationship between the Russian ruble and the yield on the 10-year Treasury as recent events have unfolded: money fleeing Russia appears to be seeking refuge, if not asylum, in the US. (Figure 1) Consequently, the signalling ability that the fixed income market provides investors is impaired by a rush of money to the Treasury market.
Risk aversion was on display not only with the drop in Treasury yields but also in the rise in the price of gold over the summer. The “crisis asset” has enjoyed a good year through the end of August: it has advanced 6.8%.3, Similarly, the increase in the trade-weighted dollar since early May reflects both a run to safety and an anticipation of normalised interest rates relative to Europe. (Figure 2)
The balance of things
The geopolitical landscape offers little hope for a de-escalation of tensions. Conflict in eastern Europe and the Middle East will continue to feature prominently “above the fold.” The global economy is at an important inflection point. Normalisation of monetary policy in the US, driven by healthy and sustainable growth, and strong growth in the UK both will cast into sharp relief a struggling euro zone economy. Recent trends in the currency bloc are troubling, but not irreversible. A well-executed targeted long-term refinancing operation (TLTRO), a quantitative easing (QE)/asset-backed security purchase program, and a credible asset quality review of euro zone banks all will help resuscitate a wheezing European economy. All of this helps make the case for euro zone equities, as their valuations suggest the future holds more of the same.
Growth in the American economy is gathering pace
As the growth scenario becomes more established, the case for equities at the expense of fixed income also will become more apparent. Investors looking beyond developed markets will find new opportunities in emerging markets, which previously have been ignored.