After slowly easing into the summer lull, market volatility unexpectedly picked up in the week ending 11/08/17. The S&P 500 equity index plunged by 1.4% in the largest retreat since May and the VIX index, which reflects a market estimate of future stock market volatility and is often interpreted as a measure of fear, spiked to its highest since November 2016 (see Exhibit 1 below).
Exhibit 1: Following one of the calmest periods for stockmarkets since the 1960s the VIX index spiked sharply upward during the week ending 11/08/17Source: Bloomberg, BNP Paribas Asset Management, as of 04/08/17
Government bond and commodity markets moved accordingly with the US 10-year benchmark interest rate dropping to 2.2% and gold rallying back to the highs of the year. Market participants had to reconcile two forces pulling in opposite directions: solid economic data on the US economy on the one side and intensifying geopolitical tensions on the other.
US economy doing well…
Starting with the positive camp and leaving slightly disappointing inflation aside, US data remained strong. Small business optimism rose to a level only seen around a dozen of months over the last four decades and two reports corroborated the improvement in the labour market. Firstly, job openings surged to 6.163 million in June 2017, marking the highest reading since the Bureau of Labor Statistics (BLS) began collecting this data in 2000. While actual hiring slowed, it remained just shy of the December 2015 post-recession peak and the sharp increase in job openings will likely result in payroll gains that will be sufficient to drive the unemployment rate even lower in the not too distant future.
Secondly, the employment report for July was stronger than economists had estimated in almost all categories. Non-farm payrolls rose by 209 000, reflecting broad-based growth across industries, and the labour force participation rate, especially among prime-age workers, increased for the second consecutive month. The unemployment rate edged down to 4.3% (see Exhibit 2 below) and average hourly earnings growth picked up to 2.5%.
Exhibit 2: The US unemployment rate fell one-tenth of a percentage point to 4.3% in July 2017, matching the 16-year low reached in May (the graph shows changes in the US unemployment rate between 31/08/04 and 31/08/17).
Source: Bloomberg, BNP Paribas Asset Management, as of 04/08/17
…but geopolitics take a worrying turn
Disconcertingly, tensions between North Korea and the US have escalated. New UN Security Council sanctions over North Korea’s growing missile testing programme triggered fierce comments from North Korea, which were followed by US President Trump warning that the US stood ready to unleash “fire and fury like the world has never seen” and North Korea threatening the US territory of Guam.
While uncertainty has clearly risen and the consequences for financial markets would be significant, we believe a military confrontation between the US and North Korea remains a relatively modest-probability event. We expect current investor risk aversion and market volatility to prevail as long as the rhetoric continues. At the same time, a diplomatic solution, potentially arranged by China, remains our base case.
For markets, this should help resolve the current tug of war between negative geopolitical developments and positive economic trends in favour of the latter.
Written on 14/08/2017