• Stocks fell last week amid geopolitical concerns, including Iraq, EU sanctions against Russian, and now prospects of an independent Scotland.
  • In the U.S., the data continue to point to a strengthening economy resulting in a stronger dollar and higher interest rates.
  • The flip side of the stronger dollar is weakness in other currencies. In Japan, this is providing a significant boost to local stocks, a trend we expect to continue.

Stocks Falter on Geopolitical Risk and Higher Rates

U.S. stocks fell last week amid geopolitical concerns and rising interest rates. The Dow Jones Industrial Average lost 0.86% to close the week at 16,987, the S&P 500 Index dropped 1.05% to 1,985 and the Nasdaq Composite Index slipped 0.33% to 4,567. Meanwhile, the yield on the 10-year Treasury rose from 2.46% to 2.61%, as its price correspondingly fell.

Despite tensions overseas, the data continue to point to a strengthening economy in the U.S. This, in turn, is resulting in a stronger dollar and higher interest rates. But the flip side of the stronger dollar is weakness in other currencies. In some instances, notably Japan, this is providing a significant boost to local stocks, a trend we expect to continue.

A Wee Bit of Drama Over Scotland

Investors wrestled last week with a slew of geopolitical concerns, including a surprising one. The prospect of renewed American military involvement in Iraq and additional EU sanctions against Russia were joined by a new worry: the prospect of an independent Scotland.

The Scottish issue is particularly interesting. Although investors were aware of the impending vote all year, few thought the referendum had much chance of passing. Over the past two weeks, however, several polls have suggested a realistic chance that Scotland will vote for independence this week, a development that seems to have taken most by surprise.

What are the ramifications if the Scots vote "yes" for independence? Obviously, the vote is most important for the U.K., but Scottish independence would have broader significance as well, particularly for the rest of Europe. At the very least, sterling and other U.K. assets would likely come under additional pressure. In addition, given that Scotland is typically more pro-European Union than the rest of the U.K., a departure could raise the odds of an eventual U.K. exit from the EU, which would only add to uncertainty in the region. It may also embolden other separatist movements, such as Catalonia in Spain.

For now, our vote is on a narrow victory for a continued union, but should Scottish independence prevail, investors should prepare for some uncertainty for the broader European Union.

Stronger U.S. Economy Pushing Rates Up

Aside from geopolitical issues, the other factor hurting stocks last week was concern over rising interest rates and the potential for an earlier-than-expected Fed rate hike.

Most recent U.S. economic data have been comfortably above expectations. Last week provided more evidence that the U.S. economy should grow substantially faster in the second half of the year than the first. Retail sales rebounded in August and July's number was revised higher (although average monthly gains for 2014 are still only at their post-recession average). In addition, other economic measures — notably manufacturing and housing related — have been substantially stronger than expected. As a result, a measure of economic surprises is now at its best level since early 2013.

The consistently strong data have pushed 10-year Treasury yields to their highest level since early July. The move on the short end of the curve has also been significant. Following the release of a Fed note suggesting that investors may be underpricing the potential for an early hike, the yield on the two-year note approached 0.60%, the highest level since spring 2011.

"Amid all the drama on the geopolitical stage, where might investors find opportunity? We’d point to Japan."

Japanese Stocks Worth a Look

Amid all the drama on the geopolitical stage, where might investors find opportunity? We'd point to Japan. Higher interest rates and a stronger U.S. economy continue to push the dollar up and other currencies down. Last week, the Japanese yen hit a six-year low against the dollar. Weakness in the yen, coupled with the prospect for additional purchases of domestic equities by Japanese pension funds, has been a tailwind for the country's stocks. Last week, Japan's Topix Index hit its highest level for the year. And despite a 17% rise from the spring lows, Japanese stocks remain cheap compared to other developed markets, particularly the United States. As such, we continue to see opportunities in this market.

What's Ahead for Small Caps?

As we are likely to approach a period of tightening monetary conditions, Russ Koesterich offers his outlook for small cap companies.

Market Perspectives

Our experts take a deep dive in analyzing the outlook for key sectors of the financial markets across an array of asset classes.

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