Long-term implications of a disconnect between news and strong equity markets

Market Realist

Disturbing headlines, strong equity markets: Why the disconnect? (Part 2 of 2)

(Continued from Part 1)

In the short term, recent market action isn’t as irrational as it might appear. First, there’s no clear link between these events and near-term economic or earnings growth. Yes, an escalation of violence in Ukraine could lead to increased sanctions against Russia and   potentially slower growth in Europe, but thus far none of the parties involved in the crisis seem inclined to up the ante.

Second, over the past five-years investors have been conditioned to “buy the dips.” Anyone who bought equities during the U.S. debt ceiling debacle or the showdown over European sovereign debt has been well rewarded. Finally, while these issues are obviously significant from a geopolitical perspective, some have little systemic significance for the global economy. The events in the Ukraine and Thailand are national in nature, and together these countries account for less than 3% of the MSCI Emerging Market Index.

However, while investors may be right to give a low weight to short-term impact of the front-page headlines, the headlines’ long-term impact may be a different story. Wars, military coups, and sanctions are rarely good for global economic growth. Nor will the pressure to increase military spending – a reality faced by the United States as well as Europe and Japan – help already strained government budgets. If there was a “peace dividend” at the end of the cold war, western governments may face a “geopolitical tax” in the coming decades.

Finally, the growing populism – evident in the outcome of recent European elections – raises the risk of misguided policies that could add   drag   to an already sluggish recovery. To be sure, none of these potential long-term effects are likely to hurt markets in the near term, but ironically investors are becoming more acclimated to the risks at a time when their cumulative impact may be starting to impact global growth, risk premiums or both.

For investors wondering how to respond to the potential long-term impact of world news headlines, there is no single answer, but I would suggest three rules of thumb: diversify, have some small portion of your portfolio allocated to “cheap insurance” assets that should do well in a crisis, and   emphasize value.

On the latter, it’s not that cheaper assets will be immune when and if this year’s headlines lead to next year’s crisis. Rather, it’s probably easier to avoid a meltdown in your portfolio if you own assets that reflect the world’s imperfections.

Sources: BlackRock, Bloomberg

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist.

Market Realist – It’s very hard to time the market and it’s hard to call a bubble until it bursts. Savvy investors position their portfolio to withstand a market fit. While investors may not like the feeling of uncertainty, a worse feeling results from getting taken by a market surprise with a naïve portfolio strategy. Investors should embrace the feeling of uncertainty as a sign to bullet-proof their portfolio in case the unexpected happens.

To learn about the impact the Iraq crisis is having on U.S. markets, read  Key macro implications of the Iraq turmoil for US investments .

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