Market review: A sea of black swans
by Kristina Hooper, Global Market Strategist, Invesco Ltd., Invesco Canada
One of the key themes that I anticipated would affect markets this year is disruption. I have maintained that disruption would likely come in different forms: geopolitical risk and monetary policy risk. (There is one additional form – disruption caused by innovation – that will be addressed more fully in a future commentary.) At the risk of sounding like a broken record, I must underscore the concerns I have articulated time and again about geopolitical risk. In many ways, these risks can be viewed as black swan events – difficult to predict, but with far-reaching potential consequences.
North Korean standoff rattles capital markets
Top of mind is, of course, North Korea. In the past week, tensions between North Korea and the U.S. escalated further – enough to finally have an impact on capital markets. The United Nations Security Council voted 15 – 0 last week to impose new sanctions on North Korea in response to its continued testing of intercontinental ballistic missiles. This was a victory for the U.S., as both China and Russia voted in favor of the resolution. These sanctions, which target North Korea’s key exports, are estimated to reduce the country’s export revenue by about $3 billion, according to the U.S. Ambassador to the United Nations.
That set off a war of words between the leaders of North Korea and the United States. The rhetoric rose to the level of serious threats, causing the financial markets to shudder. Global stocks fell, gold saw increased demand, and safe-haven sovereign bonds, such as U.S. Treasuries and German bunds, rose. As a result, the yield on the U.S. Treasury bond fell from 2.36% to 2.19% from July 11 through Aug. 11, while the yield on the German 10-year Bund fell to 0.38% from 0.55%, and the yield on the French 10-year note fell to 0.68% from 0.92% – both over the same one-month period.
China’s role in tensions between North Korea and the U.S.
The U.S. is placing a lot of importance on China’s potential role in the resolution of tensions with North Korea. However, China has been clear that the U.S. is not exactly an ally. The Global Times, which has historically been a proxy for the Chinese Communist Party, stated that if North Korea launches missiles that threaten U.S. soil and the U.S. retaliates, China will remain neutral. However, if the U.S. and South Korea carry out strikes and try to overthrow the North Korean regime, China will then retaliate against both countries. This puts the U.S. between a rock and a hard place, and is arguably emboldening North Korean strongman Kim Jong Un.
So, given this difficult situation, what happens next? It seems that the U.S. may be trying to use trade issues with China in order to take an aggressive stance with North Korea. Yesterday, President Trump signed a memo that will set into motion an evaluation of possible Chinese intellectual property violations. If an investigation does occur, the U.S. could seek remedies, including tariffs. (Section 301 of the U.S. Trade Act of 1974 allows the U.S. to place a tariff on another country without Congressional approval.)
This memo was supposed to be signed earlier, but President Trump reportedly wanted to wait until after receiving China’s support in the UN Security Council for North Korean sanctions. China’s response was to warn the U.S. that an intellectual property investigation may trigger a “trade war.” The reality is that it behooves China to keep North Korea’s current regime intact. As a result, I believe it is unlikely that China will be able to provide the solution that the U.S. seeks. And current trade posturing could aggravate the Sino-American relationship, pushing China closer to North Korea. While the situation has cooled for the moment, we need to be prepared for the likelihood that tensions between North Korea and the U.S. could flare up again.
At what price would Russia support U.S. sanctions in North Korea?
Russia was the other pivotal country on the UN Security Council whose support the U.S. needed in order to secure new sanctions against North Korea. Now that Russia has voted, the question is what it will request in return. The price may be silence when Russia conducts its “war games” in Europe next month. These war games are a Soviet-era, wide-scale military exercise known as “Zapad,” which was reinstated by Vladimir Putin in 1999. Zapad can be considered both military training and Russian military posturing. Western observers have estimated that as many as 100,000 Russian personnel may be involved, although Russia has pegged that number at fewer than 15,000. Previous Zapad exercises have been significant, with the last one in 2013 reportedly involving approximately 75,000 troops and personnel.
Eastern European nations are already expressing concern that Zapad may be a Trojan horse – a way for Russia to enter countries such as Belarus and then stay with the intent of invading nearby countries such as Ukraine or Poland. For example, only a few months after the last Zapad, Russia used troops that it deployed into Crimea and its vicinity as part of a military exercise in order to annex Crimea. Russia refuses to be transparent about the details of its planned war games, so it would be difficult to know whether military movements are merely an exercise, or something more significant. NATO is clearly a more vulnerable institution today than it was just a few years ago, so it stands to reason that Russia might test NATO with a military incursion. While unlikely, any actions on the part of Russia beyond what would normally be expected from a training exercise could result in fear, market volatility and a flight to safety.
Uncertainty reigns in Britain and France
Britain and France are experiencing their own set of challenges. However, I am hopeful that geopolitical risk can decrease from this point. Brexit negotiations are reportedly hitting roadblocks – largely because of infighting within Prime Minister Theresa May’s own cabinet. Polls show greater public disapproval of Brexit, with some even lobbying for a second Brexit vote. Others are critical of Philip Hammond, Britain’s Chancellor of the Exchequer, and his desire to extend the Brexit negotiation period. While uncertainty surrounding the May administration’s stance on Brexit negotiations could create short-term anxiety and a drop in business capital investment, I am optimistic that it could also result in a more thoughtful Brexit. After all, diversity of thought can ultimately lead to a better outcome.
In France, President Emmanuel Macron’s approval ratings have plummeted, suggesting his ability to execute his agenda will be hampered. However, I am not too concerned about negative public sentiment, which should be expected, given that Macron’s proposed reforms could be a difficult pill for France to swallow. President Macron’s En Marche! party has a majority in the National Assembly, which should enable him to bring his plans to fruition if he can overcome recent gaffes. More importantly, French business sentiment is at a five-year high, which could spur greater business investment.
Trump agenda stalls amid tensions with Congress
Finally, in the U.S. last week, geopolitical risk escalated on the heels of tensions between President Trump and Senate Majority Leader Mitch McConnell. A deteriorating relationship between the President and his own party in Congress does not bode well for the many agenda items that we will be watching once Congress returns from recess. With time running short, I believe the debt ceiling should be the first order of business. However, there is significant uncertainty around whether Congress will be able to raise the debt ceiling. The closest the U.S. has come to not lifting the debt ceiling occurred in the summer of 2011. This resulted in the most tumultuous week for U.S. capital markets since the global financial crisis, as global stocks fell dramatically (the Dow Jones Industrial Average plunged more than 500 points in one day), and a flight to safety led bond investors to, somewhat ironically, U.S. Treasuries.
Who will chair the Federal Reserve next year?
With regard to monetary policy risk, there is a lot on the horizon. For example, investors will need to assess the impact of U.S. balance sheet normalization on the capital markets; this process is likely to start sooner rather than later. In addition, a new Federal Reserve chair could be in place in just six months. This means there may be a very different approach to monetary policy; a data-dependent rate hike cycle may soon be a thing of the past.
However, we may not know much about the new chair’s “monetary policy ideology” if he or she is an unconventional choice – one pulled from the business world, rather than from academia. The beauty of choosing an academic is that he or she has likely articulated his or her positions in writings; choosing someone from the business world means they likely have not. What’s more, that person may not even have an ideology with respect to monetary policy. This could be an added source of disruption, given how much markets have come to rely on transparency, communication and even “pre-communication.”
As we look ahead to the potential for greater geopolitical risks and more black swans of varying sizes, investors should give thought to downside risk mitigation in their portfolios. Those looking for added diversification may wish to consider alternative asset classes, such as real estate, market-neutral or long/short strategies, or even gold.
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