As predicted for 2017, geopolitical risks must be monitored, as events of the last few days make clear.
“Geopolitical risks to markets, presented by how North Korea’s behaviour conditions the Trump administration’s response, may well overshadow all other developments over the coming week,” says Derek Holt, vice-president and head of capital markets economics at Scotiabank, in a weekly economics report.
A more positive mood rules the situation today, as China announced sanctions on North Korean products. The move’s being interpreted as an attempt to bring North Korea in line over its nuclear and missile programs.
Still, investors should continue to monitor developments in North Korea, which on Tuesday celebrates Liberation Day, when the country marks the end of Japanese rule.
“It’s not inconceivable that this date could be a possible day on which [North Korea] could test Japan’s resolve and ability to shoot down missiles as Japan has indicated, or to do so in other ways,” says Holt.
Another potentially high-risk event is the August 21 timeline for planned military drills by the U.S. and South Korea “that always raises the North’s ire,” says Holt. “These events will be the dominant focus over the coming week into the next.”
Investors bullish — for now
In a weekly economics report, BMO senior economist Robert Kavcic says investor sentiment likely has plenty of room to chill further, beyond that shown due to geopolitical risks, because many measures indicate “optimism and complacency typically seen late in the cycle.”
For example, despite the headline drama, the S&P isn’t even 2% off its record close, and the 30-day average volatility measure is relatively low. “The remarkably steady and relentless march higher in stock prices has led to actual 100-day average S&P 500 volatility readings that match the lows seen in 2006 and the early-1990s,” he says.
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Further, Conference Board survey results show that net expectations for stock price increases are coming off the highest level in more than a decade. And the American Association of Individual Investors survey shows equity allocation at highs last seen in 2007, while cash holdings are at the lowest level since 1999.
“While we’re careful not to get carried away here — equity holdings today are still roughly 6 [percentage points] below 1999 levels — the message is that investors are quite bullish,” says Kavcic. And that’s a necessary, though not sufficient, sentiment for a major market correction.
“If everyone is already bearish, bad news doesn’t do much to prices,” says Kavcic. “But if everyone is bullish, there’s no need for a correction when the news and economic data continue to drip positively. The risk here is that the latter drip of positive [and] reassuring news gets disrupted, leaving the market susceptible to an unwinding of the positive sentiment.”