This level of calm can’t last – markets are heading for a wake-up call

London Stock Exchange © Getty Images
Investors are being too complacent

Everyone said that US president Donald Trump would be good for defence stocks. So far they’ve been right – but it would appear, for the wrong reasons.

Trump did say that he was planning to spend more money on defence (as was Hillary Clinton). But he also gave the impression that the US would withdraw and be rather more circumspect about intervening around the world.

As a result, the thesis was that not only would the US spend on domestic security, cyber-warfare, and fighting Isis, but that the rest of the world would have to shell out to defend itself in the absence of the US global police force.

With the bombing of Syria, that doesn’t seem to have lasted long…

Trump does the unexpected, and markets barely blink

The last thing most people expected from Donald Trump – least of all his supporters, judging by the horrified cries of “false flag” in every newspaper comments section and across Twitter – was that he’d be an advocate of the unilateral muscular liberal interventionism school of diplomacy (colloquially known as the “You’re a bad man who’s done horrible things, so I’m going to bomb you” strategy).

You’ll have your own views on all this. My take is simply that if Iraq taught us anything, it’s that it’s perfectly possible to have entirely moral aims when you go to war (Saddam Hussein thoroughly deserved what he got), but you also have to get your execution right (we have no counterfactuals, but it’s not at all straightforward to argue that Iraq is better off today as a result of Hussein getting what he deserved).

So good intentions and moral indignation alone are not enough. That understanding, more than anything else, is what has undermined the appetite for intervention in Western nations.

Anyway. That’s all by the by. War doesn’t tend to rattle investment markets as much as you might think. They really don’t seem to have reacted to this incident at all.

And perhaps the fact that Trump is pulling this card out of the hat just now gives markets comfort. It shows he can get things done when he tries. Conflict is also inflationary – it means more spending and more trade disruption. Everyone knows that a good fight is the way to put a bit of spark into an economy – assuming it’s not bombed to bits.

However, I have to admit that I increasingly worry that there’s too much complacency around.

(I’ll also admit that I’m an instinctively bearish, cautious sort and very much of a ‘value’ mindset. So as an independent investor, you should consider balancing my views with the evidence-backed opinions of someone more instinctively bullish. Although clearly, they’re wrong and I’m right.)

In any case, it’s one thing to avoid over-reacting to the news cycle. It’s quite another to shrug off geopolitical turbulence with the outright nonchalance of today’s investors.

For a start, Trump seems to have acted somewhat spontaneously. Secondly, you now have the Russian prime minister, Dmitry Medvedev, talking of “ruined relations” and “a military clash” with the US.

This is all on top of everything else that’s going on (elections in Europe, uncertainty over Trump’s domestic plans). And yet the market couldn’t care less.

The kindling is piling up 

Robin Wigglesworth in the FT uses a wildfire analogy that I’m sure a lot of you have heard before (our own Tim Price has used it on occasion). The US Forest Service used to try to prevent any outbreaks of wildfire in the national parks. But they then realised that there was a big problem with this.

You see, if you don’t get the occasional little fire, then a whole load of dry tinder builds up, and you get a whopper – one that does far more damage than a series of little, broadly controllable fires. Once they figured this out, they allowed the little fires to burn, and they got fewer devastating ones.

It’s a good analogy for markets right now. Markets aren’t just remarkably calm just now – they’ve been on valium for most of 2017.

To use the jargon, “volatility” is low. Volatility is a measure of “uppy-downy-ness” in stockmarkets – how much of a rollercoaster ride you’re getting when you’re in the market. You expect stocks to be more volatile than bonds, for example.

An important digression here: it’s worth understanding that while volatility is often described as a measure of “risk”, it really does only refer to the ups and downs of a market. You can think of it as the risk of losing sleep, or the odds that at some point you’ll be sitting on hideous paper losses in an investment.

However, volatility has nothing to do with what I’d consider a far more important risk indicator – the risk of permanent capital loss (ie bankruptcy).

Volatility can be thought of more as a measure of how much and how often an investment will test your nerves, and as a guide to how long you should be willing to hold it to avoid getting a nasty shock when you cash in. So that’s just something to bear in mind when people talk about risk and volatility.

Anyway, getting back to the main point – a bit of volatility is healthy for markets. As Wigglesworth puts it, “corrections are the necessary wildfires of financial markets. They might be painful and even scary, but sell-offs clear out froth and leverage that could build up into something far more dangerous unless checked by periodic bouts of turbulence.”

But we haven’t had much volatility at all in 2017. Which is all the more surprising given all the jitters about politics on both sides of the Atlantic. Central banks and their adherence to the “Greenspan put” have certainly suppressed volatility over the last few decades, and that’s trained investors into a “buy the dip” mentality.

But that environment is changing too. Central banks still want to help markets out. But that’s trickier to do in a rising rate environment, and it’s particularly tricky to do when almost every asset class is historically overvalued.

Sometimes markets are priced for everything going wrong (2009, for example). That’s when you pile in. Sometimes they’re priced for nothing going wrong. That’s when you keep your powder dry. Today feels rather like one of those moments. The chances of something happening to spoil the calm are high.

Merryn

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