Equity markets fell and volatility returned to markets due to the sabre rattling between North Korea and the US. Led by two of the most unpredictable leaders in the world, North Korea and the USA have been trading escalating salvoes of rhetoric which has heightened fears of war.

Valuations do not cause bear markets but they do define the extent of drawdowns. On this count, equity and credit valuations are at very stretched levels and if a bear market is triggered, when one includes the propensity for liquid markets to overshoot, the downside could be significant. That said, barring an all-out war, investors remain cautious and have significant cash and protection to weather normal turbulence. VIX has been low until recently but SKEW has indicated that implied volatility has been low because of chronic call writing rather than complacency, and call writing is not the strategy of investors who see upside. Cash levels have also remained elevated even if they have come down from the beginning of the year. There is sufficient caution and thus dry powder to see opportunistic buying supporting the market even at elevated valuations. We are not calling this healthy, only observing the facts.

Back to business:

Inflation has been conspicuously weak in the data. Last week, US CPI disappointed forecasts for a 5th month running. This will shift expectations for further interest rate hikes but perhaps not so much for balance sheet normalization as lower inflation expectations will actually provide the Fed latitude to exit. There is a small risk that the Fed is mis-estimating the marginal effect of interest rates on inflation. This Neo Fisherian view asserts that higher rates cause higher inflation. This is not true under all conditions but given recent policy ineffectiveness, could be the case today.

We have long held that the world has been a trade war for the last 8 years. We also noted that there has been a rebound in international trade in the last 12 months, with an associated recovery in manufacturing and industrial commodities. Under our scenario, there is a limit to the recovery the signs of which will manifest in trade data. The first signs of weak trade data are beginning to show, even as Asia recovers from a manufacturing slowdown. We continue to see growth in Asia but with a domestic complexion, and we expect this to continue. On the trade front, however, the rebound may be beginning to slow. Our positioning in Asia favours domestic and smaller companies with less international exposure.