When fear abounds.....

Thursday, 24th August 2017 10:32 - by David Harbage

In the month of August to date, international news bulletins have been dominated by escalating tensions between North Korea and the United States of America. The prospect of nuclear missiles being directed in anger – rather than as ‘test’ exercises - to large centres of any population is unthinkable, and it is therefore unsurprising that the recent spat has cast a dark cloud over global stock markets including the UK equity market.

Renowned US investor Warren Buffet once famously said,”a wise investor should be fearful when others are greedy, and greedy when others are fearful”. The stock market can often appear illogical in terms of its performance or behaviour – usually explained by financial assets being priced with a different timescale in mind (looking beyond current events to the probable outcome). Earlier in the summer, this blog highlighted the very low level of volatility (which measures the magnitude of daily movements in share prices) which has, perhaps surprisingly, prevailed in the US and UK stock markets since 2010 – essentially post the financial crisis – despite political shocks and other dramatic events. However, over the past two weeks, volatility (which is best measured by the VIX index) has picked up sharply from near record lows to exceed its longer term five and ten year average levels.        

How should investors, existing or prospective, respond to such geopolitical concerns which the market now appears to share – based on the very recent heightened volatility or turbulence in stock prices, if not yet in actual valuation level (best evidenced by indices)? Perhaps adopting an ostrich approach (hoping normality resumes when removing one’s head from the sand), signing up to the ‘all material assets become worthless in a fiery demise’ (another ‘do nothing’ strategy) or being a contrarian investor, per Warren Buffet’s suggestion mentioned above. The latter may require particular courage because we can only look back with ‘a sigh of relief’ or the benefit of hindsight after a crisis and the trauma seems much less pronounced than at the time of heightened uncertainty – when history was close to having taken a different direction.

Speaking of history or reviewing past geopolitical crises – and onset of conflict in particular - as an indicator of how the current North Korean threat is likely to progress and impact global equity markets, one can take comfort as typically markets recovered after an initial fall. Perhaps the Cuban missile drama in October 1962 comes closest to replicating the current situati on; back then the US stock market fell by 8% (and the UK retreated further down 10%), but both recovered their poise very quickly – within ten days as President Kennedy took a firm stance with the threat posed by Soviet missiles based within range of the American mainland. The conflict in Vietnam, notably the Tet offensive in January 1968 prompted a 7% fall in the US equity market – and recovered to its pre-event level one month later.

Subsequent conflicts have prompted a more significant adverse response (and a longer recovery time): August 1990’s excursion into Kuwait in response to Sadam Hussein’s invasion resulted in a 16% fall in markets and – although the ‘Allies’ brought an end to this conflict quickly – it took US equities almost four months to get back to pre-war levels. The October 2001 invasion into Afghanistan prompted a 26% fall in US equity – which took fourteen months to claw back - and the twin towers atrocity of September 2001 knocked 13% off equity market valuations, which was recovered in less than three weeks. Every circumstance and event is different and will also be influenced by other factors such as the state of the economy and less tangible ones, like sentiment, at the time. For instance US growth was falling back at the times of the Kuwaiti war and the twin towers tragedy.

The South Korean economy and its stock exchange is a significant one amongst emerging markets in Asia Pacific – best known for a strong IT industry and corporate names like the electronics giant Samsung. One might anticipate that the latter has already fallen back significantly in the region’s current heightened tension; following the progress, or otherwise, of that market could provide an early guide to local sentiment have already. So it might surprise to learn that the Kospi (Korea Composite stock index) is close to its all-time high, having risen by more than 15% in 2017 to date.

Clearly there is a lot of diplomatic effort (just below the presidential level) in both the US, North Korea and South Korea to resolve the current apparent impasse. In addition, nations which can exercise influence – economic and otherwise – on the Pyongyang administration can be expected to be working hard to reduce tensions: Russia has supported economic and financial sanctions and, even more importantly, China has gone public in criticising North Korea’s foreign policy. A ‘cold war’ benefits no-one, except defence contractors perhaps, so while Supreme Leader Kim Jong-un and President Trump may sound aggressive – their ‘bark’ is, almost certainly, ‘worse than their bite’.      

History suggests that the economic landscape - rather than the geo-political one – is the prime driver of equity markets. While domestic news continues to indicate that the UK is experiencing a ‘flat spot’, characterised by consumers (the main contributor to growth) struggling to feel ‘better off’ – by reference to disposable income – it must be remembered that the multinational-dominated FTSE100 index is a reflection on a global economy which is performing reasonably well.

If private investors in company shares are becoming fearful (for whatever reason, ranging from a global Armageddon to a post-Brexit Britain), the opportunity to review their individual investments is never one to be shunned. Too many adopt a ‘buy and hold’ policy, which can equate to a ‘buy and forget one, rather than actively remain on alert to any deterioration in the prospects for a business or asset class. Beyond the fundamentals of how well the company is trading, the smart investor will be watching the valuation – appreciating that the more highly valued a business, the greater is potential to fall.

Being mindful of any changes in profit forecasts would represent such a prudent monitoring exercise, as well as shorting activity on the part of hedge funds. This week brought a painful case to light as the premium rated shares of the door-to-door credit provider Provident Financial fell from 1750p to 661p on announcing a disappointing trading update; something which had been flagged by a deteriorating trend in earnings and the establishment of a 4.5% (which is large for what was a FTSE100 constituent) short position in the equity.