By Kerry Craig
Western equity markets have been in a period of consolidation and have largely moved sideways since the end of May. There have been renewed concerns about stability of the eurozone economic recovery as well as heightened geopolitical risks in the Middle East and eastern Ukraine.
Take a step back, however, and investors may see they face the same landscape they did a few months ago. That is one where global growth is incrementally improving, inflation is largely in check in the developed world, and monetary policy continues to be very accommodative; all reasons to maintain a cautious overweight to risk assets.
There has been a noticeable downshift in economic momentum in the eurozone over the last few months – mainly driven by the larger economies of Germany, France and Italy. But coming into the year we expected a fragile and uneven recovery, and that is what we’re getting. PMI numbers were weaker through June (but have since recovered in July), some business and consumer confidence measures have slipped, retail sales have softened and most recently the industrial production figures missed expectations. It’s hard to deny that the economy has slowed but we continue to expect a very modest expansion.
Over the coming weeks the macro may become less important as markets focus on the corporate earnings season. After many quarters of disappointing earnings growth the expectations for the current season could be described as modestly optimistic. A turn in the earnings cycle is crucial for the continuation of the European story and to justify current market levels, as well as further gains. But the ingredients for better earnings are in place; the slowdown in emerging markets and the stronger euro that have been blamed for previous poor performance have begun to reverse.
The new risk to the eurozone’s recovery will be the potential impact of any new sanctions, and counter sanctions, put in place against Russia. However, for the sanctions to be meaningful they would need to lead to a curtailment of energy exports from Russia into Europe or create a significant hit to global confidence and appetite for risk. There is a chance that the tragedy of the downing of a passenger jet over eastern Ukraine could lead to a quicker resolution to the crisis.
One of the most surprising aspects of markets in the last few weeks has been the lack of market reaction to the spike in geo-political tension. Geopolitical risk is nothing new and the current hot spots have been that way for many months. The indifference by markets may be a function of two things. Firstly, that the economies embroiled in civil strife (excluding Russia) represent only a fraction of the world’s economic growth and an even small share of equity market capitalisation. Secondly, and perhaps more importantly, is that as long as central banks continue to supply ample liquidity to global financial markets then volatility will be suppressed.
Investors should focus on the risks they can quantify, the biggest one being monetary policy and the path of interest rates. Just as central banks have the ability to dampen market volatility they can also create it. The US Federal Reserve’s outlook for the US economy still seems too dovish, and while the lower than expected June inflation figure provides a small reprieve, inflation looks to have troughed and inflationary pressures could build as the unemployment rate continues to fall. It is unlikely that the Fed will be able to change gears on monetary policy without adding to market volatility – something we will be watching close in the months ahead.
Kerry Craig is a market strategist at JP Morgan Asset Management
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