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• The selloff in equity markets last week may signal more turbulent times ahead
• US markets must adjust to less liquidity from the Fed, while Japan faces higher interest rates
• Fundamentals remain positive, however, so investors are cautioned not to overreact
• We have published our latest Strategic Outlook; you can view it here

The eurozone crisis is contained, but resolution requires overcoming a substantial and long standing argument between France and Germany over the development of the European project. Mr Hollandes recent call for further economic union has not been echoed by the German government. Germany, though not necessarily against an economic union, demands political union first since it wants some say in how transfers from the core to the periphery will be used. France and many other eurozone countries are wary of a political union dominated by Germany. Before we can have a banking union, eurobonds, and the fiscal and economic union that will once and for all resolve the euro crisis, this fundamental division between members has to be bridged.

Fasten your seatbelts

The sharp selloff in the Japanese equity market last week set off a broader reset in equity markets, with the MSCI All Country World Index (ACWI) dropping 1.5%. A trigger for the dramatic drop in the Nikkei (7.3% on Thursday) is likely the spike in Japanese government bond (JGB) yields; for the ten-year JGB, yields have jumped by 40 basis points (bps) since 4 April 2013. The negative impact on equity markets and the economy from rising bond yields has been anticipated even if it has arrived sooner than expected. As we discussed last week, the near-term factors supporting the Japanese equity market remain in place — yen depreciation and relative underperformance vs. other developed markets. But quantitative easing (QE) in Japan poses its own, unique problems. The Bank of Japan’s (BoJ) asset purchase programme is similar to QE in the US and UK in that the goal is to lower interest rates on government bonds, forcing investors to seek out assets with better returns. But it is different in that it is also part of an intentionally reflationary programme, while in the US or UK inflation is an outcome to be avoided. Ten-year inflation expectations in Japan have risen sharply since the end of last year (see Figure 1), so the BoJ’s programme has already succeeded in changing investor perceptions. But JGB yields would inevitably have to reflect higher inflation and it is not clear how the BoJ intended to offset the risk this poses to portfolios with significant JGB investments. In contrast to the US, where the majority of Treasuries are held by foreigners, and banks own just 2% of the market, in Japan banks and insurers have more than 35% of outstanding JGBs on their books. It is no coincidence that the financial sector fell the most on Thursday, dropping more than 9%.