Tug of war

14 Aug 2017

  • Market volatility due to intensifying geopolitical tensions
  • US economic data remains healthy
  • Risk aversion should ease as geopolitical risks decline

After slowly easing into the summer lull, market volatility unexpectedly picked up last week, providing relevant reading material for investors, including those currently enjoying their summer break. The S&P 500 plunged 1.4% in the largest retreat since May and the VIX index, which reflects a market estimate of future stock market volatility and is often interpreted as a measure of fear, spiked to its highest level since November 2016 (see Chart of the week). Government bond and commodity markets moved accordingly with the US 10Y benchmark interest rate dropping to 2.2% and gold rallying back to the highs of the year. Market participants had to reconcile two forces that were pulling in opposite directions: solid economic data on the one side and intensifying geopolitical tensions on the other.

Starting with the positive camp and leaving the slightly disappointing CPI print aside, economic data in the US remained solid last week. Small business optimism picked up again to a level that has only been seen around a dozen of months over the last four decades and two reports corroborated the ongoing improvement in the labor market. First, job openings surged to 6.163 million in June, marking the highest reading since the Bureau of Labor Statistics (BLS) began collecting this data in 2000. While actual hiring slowed a little, it remained just shy of the post-recession peak logged in December 2015 and the strong increase in job openings will likely result in payroll gains that will be sufficient to drive the unemployment rate even lower in the not too distant future. Second, the employment report for July was stronger than economists had estimated in almost all categories. Nonfarm payrolls increased by 209,000, reflecting broad-based growth across industries, and the labor force participation rate, especially among prime age workers, increased for the second consecutive month. The unemployment rate edged down to 4.3% and average hourly earnings growth picked up to 2.5%.

In contrast, geopolitical tension also moved into the spotlight last week as the conflict between North Korea and the US escalated. The recent chain of events started after the United Nations Security Council decided in its last meeting to hit Pyongyang with new sanctions as punishment for North Korea’s growing missile testing program. This triggered aggressive comments from North Korea, which in turn were followed by a sanguine exchange of threats between US President Donald Trump and North Korean leader Kim Jong Un. Trump stated that the US stands ready to unleash “fire and fury like the world has never seen” and North Korea answered by threatening to attack the US’s Pacific territory of Guam with missiles that are ready to be launched as early as next week. On Thursday, President Trump said that his previous statement “maybe wasn’t tough enough” and on Friday he reiterated that “military solutions are now fully in place, locked and loaded”.

While uncertainty has clearly risen and the consequences for financial markets would be significant, a military confrontation between the US and North Korea remains a relatively modest-probability event. We expect current risk aversion and volatility to prevail as long as headlines continue to emerge on news tickers across the globe. At the same time, a diplomatic solution, potentially orchestrated by China, remains our base case and should resolve the current tug of war between negative geopolitical development and positive economic trends in favor of the latter.

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