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Geopolitical concerns increase stock market volatility

Morningstar  |  25 Sep 2017Text size  Decrease  Increase  |  
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Economic considerations may take a back seat to geopolitics in the coming months when it comes to market returns.

 

The global economic outlook remains positive. The latest JP Morgan Global All-Industry Output Index shows a good pace of global economic activity: "Overall growth was the quickest since April 2015, underpinned by expansions across the six main categories of manufacturing and services covered by the survey. With new order inflows strengthening, backlogs rising and jobs growth accelerating, the economy looks set to perform well in the coming months."

By sector, the index also showed that technology, and pharmaceuticals and biotechnology, in particular, are the fastest growing sectors, which shows that there is a fundamental underpinning for the sectors' recent popularity with investors. Forecasters are also upbeat.

The Economist surveys a panel of international economic forecasters every month, and its September poll showed that every one of the 25 countries in the survey is expected to grow in 2018. The emerging markets are expected to be particularly strong, with India expected to grow by 7.5 per cent, up from an already impressive 7 per cent for this year, and China by 6.5 per cent.

The Economist also makes its own forecasts for countries outside the most important 25: every single one of them is expected to grow in 2018, other than grossly misgoverned Venezuela.

This would normally be clearly supportive for world equities, but one significant qualification is that the positive outlook is already well built into prices, particularly in the US which is the most expensively valued of the major markets.

Currently, the share market analysts surveyed by US data company FactSet have ambitious expectations for American shares in that they expect profits for the companies in the S&P 500 Index to grow by 11 per cent in 2018, and the index to rise by 10 per cent over the next year.

This is achievable given the ongoing growth in the US economy, but it also leaves little leeway for earnings disappointments if companies, or the economy more generally, do not live up to expectations.

One possible flashpoint could be Congressional impasse over the Federal government's debt ceiling. Currently dysfunctional politics have managed only a short-term patch to the end of December, and the threat or reality of inadvertent fiscal tightening could become a problem for investors later this year.

Another potential issue is mis-steps by one of the major central banks in withdrawing the current degree of monetary stimulus. As noted earlier, all the central banks look to be approaching the process with a high degree of caution and care, but the equity markets have been roiled by a "taper tantrum" before, and might be hit again. Economic considerations may however take a back seat to geopolitics in coming months.

North Korea remains unpredictable

Nobody knows how the current North Korean difficulties will play out, or whether currently quiescent hot spots in the Middle East or the Ukraine among others will stay that way. Investors, going by the VIX gauge of expected S&P 500 volatility, are either robustly confident, on a positive view, or blindly complacent, on a negative view.

The VIX has recently signalled some degree of investor nervousness with it spiking twice in early- to mid-August and again in early September, but the equity market showed remarkably small levels of alarm given the potential threats from a nuclear-armed, hostile, and erratic North Korean regime.

The rise in the VIX, for example, was not especially large--the markets were less worried, for example, about nuclear North Korea than they had been in early 2016 about a potential slowdown in the Chinese economy, and did not last, with the VIX now back to "all clear" levels.

All going well, the clear evidence of a strengthening world economy will carry the day, and global shares will be able to make further gains.

But there is a higher than usual probability of left-field geopolitical surprises making their presence felt. That may well be why the big fund managers in the latest Bank of America Merrill Lynch survey reported increased levels of insurance protection against equity market corrections in the next three months.

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This article initially appeared on the Morningstar UK website.

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