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Missiles, health debacle, fail to douse equity party but nerves begin to show

As August began, North Korea had just launched an ICBM it boasted could reach U.S. shores, speculation swirled of global trade war, and Congressional Republicans failed to repeal the Affordable Care Act, throwing plans for ambitious tax reform into doubt as well as raising the specter of a standoff over raising the debt ceiling.

Yet markets did not blink, despite valuations many argue are already stretched, and even at a time when major central banks including the Federal Reserve are moving towards tightening extraordinarily loose monetary policy. On Aug. 2, the S&P 500 set a new record high. The Chicago Board Options Exchange's Volatility Index was just over 10, about half its historic average and near all-time lows after six years of relative calm.

"The [VIX] index was last this low when Bill Clinton took office in 1993, at a time when there was peace in the world, faster economic growth and a much smaller deficit. Should people really be as complacent now as they were then?" Oaktree Capital Co-Chairman Howard Marks noted in a July 26 memo, urging investor caution.

Investors appear to be betting not only that Pyongyang's aggressive and isolated regime is posturing rather than about to launch nuclear war, but also that President Donald Trump may yet manage to push at least part of an economically stimulating tax agenda through Congress. While last year's market euphoria over Trump's infrastructure spending plan may have fizzled, the resulting fall in the dollar is now boosting U.S. competitiveness and corporate profits. Another reason for continued bullishness comes from a gathering economic recovery in the eurozone, which some thought to be on the verge of collapse only a few years ago.

At the same time, while on the surface markets may appear undisturbed by geopolitical turbulence, currents below are gaining force which may indicate gathering concerns. Global macro hedge funds, which can make profits even during market downturns, led all other strategies for investor inflows in the second quarter of 2017, with $5.2 billion in allocations bringing their total capital to $579.2 billion, according to HFR, an industry data provider. That is despite lagging returns: the strategy is down 0.73% year-to-date, compared to the S&P 500, which is up 10.6%.

"A landscape ripe with geopolitical tensions and perceived stretched equity market valuations drew investors into the strategy," wrote Peter Laurelli, global head of research at eVestment in a note.

Soaring valuations

The cyclically adjusted price-earnings index was 30.17 times in July, according to figures from Nobel-Prize-winning economist Robert Shiller, twice the usual average.

The last times the index was at so rich a valuation were in December 1999, at 44.20, and before that in September 1929, when it was at 32.56. Those two peaks were just before the dot-com bust and the Great Depression, respectively. Directly prior to the collapse of Lehman Brothers and the subsequent Great Recession, there was another, less dramatic run-up.

Yet even the latest announcement from Washington about tax reform gave some reason to believe there was value yet to be had in equities. The dropping of plans for a border-adjustment tax raised hopes there would be "more simplified tax reform," said Savita Subramanian, equity and quant strategist at Bank of America Merrill Lynch. This would include a cut in the corporate rate from the current 35% and a repatriation holiday for companies that have parked cash overseas to take advantage of lower taxes elsewhere.

"Stocks that would benefit most from tax cut or repatriation or trading at lower discounts to the market than where they were pre-election," Subramanian said in an Aug. 1 presentation, "we still haven't seen absolute euphoria in stocks at this time."

Overseas trade

Another support for the sustained equities rally is a strong comeback by the eurozone, after debt crises in Greece, Ireland, and its southern periphery led some to question its continued existence. While this renewed strength is luring some money abroad, with international long-term mutual funds and exchange-traded funds seeing six times the inflow of investor money than that into their domestic equivalents so far this year, according to the Investment Company Institute, it is also pulling the dollar down from highs hit after the U.S. presidential elections, providing a welcome boost to American manufacturing.

The ISM manufacturing index came in at 56.3 in July from 57.8 in June, keeping that portion of the economy well within expansion mode, Wells Fargo Securities analysts wrote in an Aug. 1 research note.

"Our outlook is for about 2.5 percent growth for industrial production in the second half of this year," Merrill Lynch Wealth Management analysts wrote recently, noting: "Eurozone in general and many nations in particular (like Germany, Italy, Sweden and France) have posted stronger real growth in gross domestic product than the United States."

Emerging-market currencies are also gaining on the greenback. Mexico's peso is up almost 18% since January when Trump was inaugurated on promises of building a wall between the two countries and exiting the North American Free Trade Agreement.

"What you're seeing more and more is that these currencies are able to weather political risk – they've surprised a lot of people," said Blu Putnam, chief economist at CME Group in a phone interview.

Hedging strategies

Cautious investors, though, insist valuations are stretched. Some are turning to multi-asset hedges, including puts and calls on commodities, currencies and precious metals, said Arnim Holzer, global macro strategist at EAB Investment Group, adding that the narrowing difference between the returns investors demand on risky debt compared to bonds sold by the strongest companies may be a sign of trouble.

The spread between a Bank of America index of high-yield bonds and an equivalent measure of investment grade debt had compressed to 250 basis points by Aug. 1, down from around 630 at the start of 2016, according to the St. Louis Federal Reserve.

"It has usually been a sign of over-exuberance when high yield correlations to investment grade credit rise above low levels," Holzer said in a phone interview. "We have seen those particular correlations rise over their historical norms in 2017."

Volatility could spike unexpectedly, Holzer said, pointing to central bank moves as a possible catalyst.

"It might cause assets to behave differently than you might anticipate," Holzer said.