Near-term market sentiment: The FTSE All World index rose in August, for the tenth consecutive month. But we begin this week on an uncertain note, after the weekend’s news that North Korea has tested a large hydrogen bomb underground. Its nuclear missile program is once again rattling investor confidence. With U.S military options limited (and its Japanese and South Korean allies firmly against a pre-emptive strike), all eyes are on China. Will it oblige the U.S and tighten trade restrictions with North Korea, and so risk an economic collapse of its neighbour and a flood of refugees into China? Meanwhile there is a sense that the further the U.S Department of Justice delves into Trump’s Russian links, the more likely it is that Trump will himself look to distract media attention by baiting North Korea.
The good news is that, despite last week’s upgrade to U.S second quarter GDP growth data (from 2.7% to 3% annualised), and strong Chinese factory output numbers on Thursday, U.S, Chinese and European monetary policy looks set to remain loose and so to continue to support risk assets.
Weaker than expected August jobs growth in the U.S, and weekly earnings growth stuck at 2.5% y/y since April, both suggest limited inflation pressure coming from the labour market and the Fed may yet abandon the penned-in December interest rate hike. The ECB, meeting this Thursday, looks to be as far away as ever from tapering its asset purchase program since a strong euro (at $1.20) is a deflationary force that as a similar effect on the economy as a rate hike might. Draghi will not want to repeat the ECB’s 2011 error of tightening policy too fast, too soon, and ending the incipient euro zone economic recovery.
North Korea longer term outlook: China is North Korea’s only ally in the region, and we can assume that its patience with President Kim is becoming thin. But it too has few options. This problem may well just rumble on, with eventually the U.S and its allies learning to accommodate North Korea as a nuclear power. Similar to the emergence of China as a nuclear force to the frustration of Russia and the U.S in the 1950s. After all, it is not actually in President Kim’s interest to use nuclear missiles, because to do would invite an overwhelming response and probably the end of his family’s rule. But in the meantime, we can expect sabre rattling from North Korea and the U.S to create occasional bouts of market volatility.
Can stock market gains persist? Yes, so long as the risk-free rate remains low (by which we mean so long as bank account cash rates and core government bond yields continue to offer dismal returns to investors). With central banks in no rush to raise overnight rates, and global inflation still relatively subdued, the returns from cash and core bond markets are unlikely to improve over the coming year at least. This supports assets that can produce a yield, and that will respond positively to rising GDP growth, such as equities. But some asset classes do appear overvalued in relation to their risk, not just Argentinian 100 year bonds but parts of the U.S high yield market and possibly also the leading quoted U.S tech stocks. In view of the low risk-free returns available, any correction in these markets is unlikely to trigger an across-the-board sell-off of global stock markets or investment grade bonds, but merely see the proceeds of sales re-invested in lower risk (but still yield-producing) stocks and bonds.