It’s Hard to Relax

It’s time for a well-deserved, late-summer breather, yet geopolitical tensions continue to mount.

The dog days of summer are a time for slowing down, letting go and recharging. With any luck, equity markets will comply by staying relatively calm. Yet amid all the uncertainty and rising geopolitical tension, we understand if it feels hard to kick back and relax.

Though the sudden volatility that rattled equity markets two weeks ago has subsided, we expect choppier waters heading into November’s U.S. presidential election. Meanwhile, escalating conflict in the Middle East and Ukraine threatens to roil energy markets and push up equity risk premia, at least in the near term.

On the other hand, fresh reports of receding inflation appear to give the Federal Reserve (Fed) further ammunition to lower rates at its mid-September meeting. If the Fed does stay the course and cut rates, investors should consider putting their lower-yielding cash to more productive use as opportunities present themselves.

The Calm After the Storm

Volatility surged in early August when a long-awaited rate hike by the Bank of Japan met with a weak U.S. payroll report, thus triggering the unwinding of a massive carry trade in which investors borrowed in yen to buy U.S. stocks. Global equity markets rapidly sold off, including the high-flying Magnificent 7, while the VIX Index soared.

As my colleagues Robert Surgent and Shannon Saccocia were quick to point out, while the U.S. economy might be slowing, the decent fundamentals that underpin it haven’t significantly changed. Indeed, second-quarter earnings for the S&P 500 Index are on pace to rise nearly 11% year-over-year (though still very skewed toward larger, tech-heavy names); consumer spending has broadly held firm, evidenced by a strong July retail sales report; and a closer look at that recent payroll print showed that much of the weakness stemmed from temporary layoffs as opposed to permanent job losses.

And so what first felt like a raging storm quickly turned into a brief squall: As of this writing, the VIX Index had fallen below 20 (just above its long-term average) and the S&P 500 Index had made up all of its lost ground, though the Nikkei 225 Index still trailed its peak in July.

Meanwhile, fresh July economic data continue to support our constructive view. The NFIB Small Business Optimism Index, which captures the health of companies that employ half the nation’s workforce, edged higher last month, beating expectations. This is an important data point as small businesses have, in particular, been suffering from higher rates and tight financial conditions. As for inflation, the Consumer Price Index rose a mild 2.9% over the prior year, carving a clearer path to a September rate cut and potentially generating a tailwind for stocks.

Rising Geopolitical Tension Shouldn’t Be Ignored

Still, we can’t help be reminded that the world remains a dangerous place, and we’ve been somewhat surprised that markets have not demonstrably responded to recent escalations.

In our view, the conflict between Israel and Hamas, now in its tenth month, has the potential to widen after recent assassinations of Hamas leaders in Gaza and Iran, as well as a Hezbollah military commander in Beirut. In August, rating agency Fitch joined S&P and Moody’s in downgrading Israel’s debt, stating: “In our view, the conflict in Gaza could last well into 2025 and there are risks of it broadening to other fronts.”

Meanwhile, Ukraine’s recent incursions into Russian territory suggest the bloody struggle that began in early 2022 remains intense, and all peace talks are on hold.

Even as the horrendous human toll continues to mount, we believe broader economic impacts from both conflicts will remain primarily confined to the energy markets. Further escalation in either region could translate into higher prices at the gas pump, which could dampen the Fed’s appetite for rate cuts.

Stay Vigilant

In coming weeks, we encourage investors to look beyond the daily theater of domestic politics and consider the broader geopolitical and economic landscape and its potential implications. Rising global instability mixed with a leadership transition in Washington could boost equity risk premia in a market still likely on edge.

At the same time, we think investors who maintained healthy cash positions during the Fed’s aggressive monetary-tightening cycle may find new ways to put that money to work as short-term rates fall. For example, after the recent sell-off, Japanese equities appear especially poised to deliver attractive long-term returns, argues my colleague Kei Okamura.

For now, the beach beckons: Enjoy the fleeting days of summer—and try to relax!