For our quarterly market commentary, it is not common practice to begin with a discussion of geo-politics, but given developments in the Third Quarter, we feel it is appropriate to address the “elephant in the room”. Commentators have suggested the North Korea situation is a renewal of Cold War dynamics and game theory, similar to the Cuban Missile Crisis. We disagree. Our view is that a rogue totalitarian regime has, effectively, taken hostage two very important allies, South Korea and Japan. At this point, what is unknown, at least to the general public, is whether diplomatic channels have established explicit “red lines” that, if violated, would prompt aggressive responses. Consequently, this uncertainty has heightened anxieties with each round of bellicose rhetoric. Therefore, there is some risk associated with an “accident” – i.e., misinterpretation of rhetoric or overreaction to a development. Effective, bilateral communications are vital to maintain stability.
All experts agree that North Korea’s paramount objective is self-preservation. In order to ensure long-term viability as a sovereign entity, their government views nuclear capability as insurance. The country’s only option, apparently, is to occasionally threaten its neighbors as a reminder to the world of this capability. As is often the case with any hostage negotiation, a peaceful resolution will likely require an empathetic approach through which the North Korean government can escape the current predicament while “saving face” in the process.
Despite these tensions and other negative news flow, the stock market continued to defy gravity in the Third Quarter and posted its seventh consecutive quarter of positive returns. The financial media have devoted much of recent coverage to pundits who claim to know when the next major market correction will begin. There is also a growing chorus of market commentators that argue risk is currently underpriced, implying investor complacency. As evidence, the VIX index, a popular proxy for market risk, has generally trended lower this year. Finally, the Federal Reserve confirmed its intention to “unwind” its Balance Sheet beginning October, introducing a new uncertainty as 2017 draws to a close.
In addition to remaining on its path of gradually raising interest rates, the Fed could sell securities into the financial system to remove liquidity. Higher policy rates and forthcoming actions effectively end the era of emergency measures known as quantitative easing (“QE”). In past cycles, a tightening of monetary conditions has contributed to contractions in the economy. Often, those cycles were characterized by rising interest rates, a strengthening Dollar, and a stock market correction. Curiously, interest rates have fallen since last year’s election, the Dollar has weakened, and the stock market has continued its seemingly inexorable climb higher. The bond market is responding to a lack of higher inflation, and to the extent the consumer continues to demonstrate restraint despite rising asset values, the Fed’s ability to control inflation is facilitated. The Dollar’s weakness reflects, in part, the relative strength of other currencies. We believe the stock market remains supported by solid earnings growth and a growing economy.
In March, we cautioned that stock index performance had become concentrated around “FAANG” (Facebook; Apple; Amazon; Netflix; Google). We are now encouraged that stock market leadership has broadened beyond this select group of technology leaders. Additionally, economic improvement in Europe, Japan, and certain emerging markets has continued. However, there will be political challenges in each of these regions before the end of the year. Fortunately, Congress has temporarily spared investors the annual theatrics of the debt ceiling, effectively removing that uncertainty for the Fourth Quarter. Therefore, we approach the final quarter of 2017 with cautious optimism, prepared to act if confronted by an “accident”. We remain hopeful that diplomacy will ultimately prevail.