Investors experienced a remarkable array of events last quarter, and many of them will continue to shape and impact the path ahead.
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I turn first to geopolitics and the evolving coalition between the West and a group of Arab countries to join the battle against the Islamic State of Iraq and the Levant (ISIL) in Iraq and Syria. This represents renewed military engagement in a region where many hoped that was coming to an end – albeit a disappointing one. The ongoing conflict in Ukraine has flared with no sense of an enduring agreement between parties, and the threat of Russian irredentism casts a pall over the region. The 307-year union between England and Scotland appeared under the real threat of dissolution with the Independence vote last month.
The latest turmoil is the “Umbrella Revolution” currently unfolding in Hong Kong,1 which has nothing to do with the weather and everything to do with self-determination.2 The people of Hong Kong are agitating for universal suffrage. Under the agreement struck when Great Britain relinquished control of Hong Kong to China, the island would be governed under a “one country, two systems” framework. The people of Hong Kong get to vote for their representatives in government; however, those representatives are screened by Beijing. For those protesting in the street, this is not democracy.
Second quarter US GDP was lifted from 4.2% to 4.6%
Of all these geopolitical concerns, the conflict on the island has the potential to surprise and disrupt markets most. Hong Kong has been a remarkably successful and stable place in which to do business. Trips to the island have never failed to impress me with a picture of robust capitalism: business is the business of the place. A stable environment nurtures investment. Business can only flourish if those risking their capital have a sense that their resources are safe from expropriation, and the opportunity for a return on their capital is realised. How all this turns out depends upon how the leaders in Beijing decide to respond. Brutal crackdowns on protesters will likely, and rightfully, poison the atmosphere for investment. If a more conciliatory approach is taken and a deal is struck, then markets will likely take a more constructive view of things, since such an agreement would represent the transit to a system of popularly elected officials – just what the protesters desire.
On the economic front, the growth story we have described in these pages was once again cast into sharp relief as the revision to second quarter US GDP was lifted from 4.2% to 4.6% on higher capital investment.3 Rising capital spending is something we have been expecting for some time now, since it is an important fuel for economic growth that has not yet returned to pre-crisis levels. In the euro zone, the picture is mixed. The German economy continues to grow, but sentiment indexes such as the Ifo Surveys and purchasing manager indexes suggest the margin of growth that economy enjoys is shrinking. Overall, the slide in euro zone inflation is focusing the attentions of the European Central Bank on warming up the printing presses as they prepare a new round of quantitative easing (QE) with the purchase of asset-backed securities. Many are calling for the outright purchase of government debt in the next iteration of the program. Whether an expanded program of quantitative easing would be supported in the Bundestag remains to be seen, but a new round of QE is unlikely to happen until the recently announced program has been executed.
Markets around the globe, like the economies in which they operate, have turned in differentiated performance during the quarter. US equities rose during the period while European equities fell, reflecting the relative growth propelling the markets.4 US earnings season will commence in a few days, and expectations are for third quarter profits to rise by 7.6%.5 There is significant potential for negative surprise as the dollar‘s meteoric rise commenced at the start of the quarter. (Figure 1) In the euro zone, earnings are also expected to rise and could very well be aided by a strong dollar.
Markets appear to be at an inflection point. Recently, volatility has been more of an academic concept than an investor’s reality. As the “Great Money Print” unfolded, asset prices of every flavour rose and volatility fell. As one commentator put it, there has been a bull market in complacency. These days may be numbered. As the era of ZIRP6 closes, industrial-scale quantitative easing ends in the US, and both the US and the UK prepare for interest rate normalisation, more discriminating markets will emerge, likely bringing higher volatility. Make no mistake, markets and the economies in which they operate ultimately benefit when there is a real price for money. Markets that discriminate are the best and healthiest of markets. To be sure the best is yet to come; getting there will likely be the rough bit.