Political volatility vs. market calm

12 May 2017

The sigh of relief could be felt across all media channels last Sunday evening, when it became clear that the polls had been correct and France had chosen the moderate Emmanuel Macron over ultra-right, nationalist Marine Le Pen. However, short term investors who had bet their money on this outcome were disappointed as markets appeared to have had fully anticipated Macron's victory and provided no further upside, not even the €-Euro.

The political calm only lasted until Wednesday when president Trump made his first major political mistake by suddenly firing the head of the FBI, James Comey. There were plenty of legitimate reasons to do so back in January, when he was inaugurated, if we think back to Comey's dubious decision making in the Hillary Clinton email affair just before the election. However, now that the FBI is investigating Russian ties with Trump's campaign, his decision to suddenly push him out was bound to rouse suspicions that this is attempted intimidation of FBI investigators. Given not even Nixon dared to sack the head of the FBI there was a widespread view that he had gone a step too far with his unorthodox methods of progressing his political aims.

US stock markets disliked the prospect of a presidential '˜wobble' and fell on opening on Thursday morning. However, given - over the week - they continued to trade sideways, as they have done since late March, this tells us that politics appear to currently matter less and actual economic momentum more. On that side, the ongoing quarterly round of corporate results announcements is surprising with the best figures in 5 years. Most of the improvement has admittedly come from just the energy and financials sectors, but they matter and have been the ones that have suppressed corporate earnings averages for the past years.

Fluctuating oil prices were therefore much discussed, as was the falling demand for commodities by China. Regarding the latter, it isn't quite clear whether this is already the consequence of declining Chinese construction activity or simply falling speculative demand because of the government crackdown of unregulated wealth management products of which many were linked to commodity price movements.

As reported before, those who follow the global economy closely expect a moderation of the ever-improving economic news flow we had for the past 12 months. For the UK this was confirmed by the Bank of England's latest inflation report with additional economic reports from the ONS. Governor Carney gave a modest growth projection for the UK, but also stated that longer term forecasts were highly dependent on a soft, rather than hard Brexit.

Against this backdrop many investment strategists are highly suspicious that the markets' main risk barometer - the volatility index VIX is at one of its lowest historical readings. Are capital markets ignorant about the potential disappointments ahead? Well, not necessarily. First and foremost, the VIX reflects the status quo of expectation of variations of future corporate earnings. Given the steady, if unexciting economic growth that has just generated a round of solid corporate results, there does not seem much uncertainty about the next quarter. Yes, equity valuations are relatively high, but with business confidence improving and corporate profit growth following valuations higher, only a return of economic decline or a financial shock would be able to upset stock markets persistently.

Short term corrections are always a possibility - particularly for those who believe in the old market adage of '˜Sell in May, go away and come back on St Leger's day' (mid-September). However, in the absence of strong stress indicators like rising junk bond yields, we would most probably regard this as an opportunity to increase our equity allocations in portfolios.

As to '˜Sell in May and go away'¦' - you certainly would have missed much of last year's return potential had you followed it!

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