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Mike Moreland

August 14 , 2017

If Cooler Heads Don’t Prevail…

IF COOLER HEADS DON’T PREVAIL…

One of the phenomena of early summer was the utter calm among market participants.  Corporate earnings were generally ahead of expectations, inflation remained subdued, and global economic growth was moving forward in a somewhat synchronized expansion.  Multiple market commentators recycled the term “Goldilocks environment” for the economy and financial markets.  The Chicago Board of Trade Volatility Index, or VIX, hit multi-year lows in July. 

This changed in early August as North Korea’s war rhetoric grew more bellicose, answered in like terms by President Trump.  The VIX spiked, and last Thursday equity markets had their worst day since late last year.  U.S. government bonds rallied, reprising their traditional role as a safe haven in uncertain times.

This rising level of concern is reflected in questions relayed to our staff.  All are along the lines of, “What happens if we get into a hot war with North Korea – with a potential exchange of nuclear weapons?  What are your expectations for the markets in such an event?  What can be done to insulate my portfolio from this possibility?”

Our experience and professional education prepare us to address many what-ifs. Market behavior following a nuclear attack is not among these, for us or anyone else.  But, some things are consistent in periods of lesser crises.  Let’s look at likely outcomes if the cold war turns warm:

- Safety assets – precious metals, Treasury bonds, and the like – will skyrocket; 

- Risk assets – global equities – will plunge at first, recover upon cessation of hostilities; and

- Energy commodities will spike; others will decline.

These expectations are pretty consistent with the beginning of limited hostilities in past conflicts.  The potential use of nuclear weapons by one side brings whole new levels of uncertainty and risk.  Financial markets shut down for several days following September 11, not only to address logistical issues and honor the victims, but to allow a period of reflection on the long term implications of the event to our world.  Panic was prevented but financial markets still fell dramatically upon reopening.   

We probably won’t have the luxury of a period of enforced contemplation if events take a bad turn.  Even as recently as 2001, the major exchanges were the focal point of market activity.  Today, off-market “dark pools” operate around the clock and execute more transactions than the NYSE.  Derivative activities further enable immediate reactions – with everyone pushing through the same door at the same time.  Should worse come to worse, a temporary suspension of trading will be an afterthought – market damage will already be done.

On the less dark side, If hostilities – should they occur – are limited to conventional weapons, the basic patterns shown above should repeat.  If they do, recent history suggests near-term risks are quickly reversed.

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In sum, there are few times in recent history when political or global events maintain a long term dominance over the power of economic fundamentals on stock and bond prices.  A conflict with North Korea may be one, and will assuredly be so if China is drawn into events or a nuclear weapon is employed.  But for now, history suggests otherwise.

Our plans are to continue as we do in any environment of rising uncertainty and generous valuations.  Portfolios will remain broadly diversified with a “home country” bias.   Dividend income will be emphasized, as will fixed income credit quality.  All of these steps will help reduce portfolio risk.  We will not reverse course, sell, and sit on the sidelines until cooler heads prevail.  That may be awhile.

This entire discussion brings up a point for you to consider.  It’s been a decade since the credit crisis and last market peak.  Memories are short, and many are comfortable taking on additional risk when the pain of the last downturn is diminished by time.  The time to review your portfolio and make adjustments to your risk profile is now, not after an extraordinary event does it for you.  Call Security National Bank Wealth Management at (712) 277-6500 for a review today.

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