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Disturbing Headlines, Strong Equity Markets: Why the Disconnect?

By Russ Koesterich, CFA, BlackRock 

In recent weeks, the equity market has continued its quiet advance. Both global and U.S. indices have hit record highs amid low trading volume. On the surface, this seems unremarkable given the market's slow but steady ascent and the still benign environment of low rates, quiescent inflation and easy monetary policy that is supportive of stocks.

However, if you overlay the market's recent performance against world news headlines on the front page, rather than the business section, it's hard not to see some disconnect. In recent months, news headlines have covered the growing disintegration of Ukraine, the victories of anti-euro and neo-fascist parties in European elections, a military coup in Thailand and the U.S. Justice Department indictment of five members of the Chinese military for stealing trade secrets.

Yet, none of these events have prevented stocks from reaching new highs or equity market volatility from sinking to multi-year lows, and they haven't deterred investors from gobbling up the most speculative forms of high yield. On the working assumption that most investors do read the paper, is this simply a case of cognitive dissonance or are investors behaving rationally? My take: the disconnect may be rational in the near term, but not necessarily over the long term.

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.

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