Since last week’s blog post, Greece has been granted an extension to renegotiate the terms of its bailout package. Market volatility has been on the downtrend over the past few weeks, with another jump downwards upon this calming news, as measured by VIX positioning. There remains a couple of puzzling questions for investment participants over the medium-term in light of these confusing times, with divergent monetary policies and the risk of the Grexit temporarily subdued. To begin with, how is it possible to explain equities outperformance over the past year with tensions broiling up across the Middle East with the rise of ISIS, the deterioration in the pricing power of OPEC and the subsequent crash in oil prices, violence across Ukraine and Russia, as well as the constant vigilance over the Fed’s anticipated rate hikes?
Investors could not help but flock to the momentous gains of the S&P over the past few years, extending the bull market on the trend-following herd, combined with zero interest rate policy. Furthermore, I hypothesize that so long as the Fed has interest rates near zero, only temporary and minor corrections will persist. Clearly, geopolitical risk has not disturbed market exuberance; only the realization of one of these geopolitical risks, such as a split of Ukraine, bankruptcy of Russia, Grexit, etc. can significantly correct markets, for lack of a better term.
Why is it that Europe has been less successful in exiting the Great Recession than the United States? Since the United States has deep import and export relationships with a relatively large number of counterparties across the globe, it has effectively hedged itself from the excessive pricing power or economic distress of any single counterparty. The US labor market is more flexible than that of Europe, and consequently policy implementation has shown greater results in less time. Most importantly, government and business are simply better aligned in the United States, as we have legislation that is decidedly pro-business, ignoring the corporate tax rate (which is far less amenable in Europe). As ECB quantitative easing continues, I expect European stocks to outperform by a significant margin, and with 40% of yields in the developed world near zero or gone negative, with ECB bond buying pressuring them further downwards, perhaps there is an opportunity to carry European equities financed by shorting such bonds. -Nicholas Kodati