Will the World and the Markets (Passively) Accept Russia’s Actions?

Having bloodlessly consolidated his control of Crimea, Russian President Vladimir Putin announced he hoped there would be no shooting (e.g. military response to the invasion). Most markets rallied, regaining the ground they’d lost when the invasion occurred.

There won’t be a NATO military response: pushing the Russians out is effectively impossible in practical terms. (How the Ukrainians themselves will act is uncertain. As one analyst put it, “The only question now is whether the new Ukrainian government will accept the loss of Crimea quietly or try to retaliate against Russian speakers in Ukraine – offering Putin a pretext for invasion, and thereby precipitating an all-out civil war.”)

Stakes are Low for Europe, the U.S.

There seems to be virtually no will (especially in Europe) to impose meaningful economic sanctions on Russia. For the Eurozone, exports to Russia are 0.9% of GDP … and energy imports from Russia are important. On the surface, the U.S. has less at stake – exports to Russia are less than 0.1% of U.S. GDP – but Russia matters for Iran/Syria/Afghanistan.

Another argument of the “do almost nothing” crowd: Ukraine accounts for slightly less than 0.5% of global GDP … and is effectively broke … why is it so important that it be part of Europe rather than Russia’s problem? The EU announced an €11B Ukraine aid package, but it’s unclear what that would buy and/or how much of that money would just be used to pay Ukraine’s debt to Russia. The Crimean parliament (whether a legitimate government or not) has voted to become part of Russia and, apparently, there will be a referendum in Crimea about seceding from Ukraine to rejoin Russia. The West may declare the referendum illegitimate, but the overthrow of the prior Ukrainian government means the current government in Kiev has no strong claim to legitimacy. If self-determination is the moral high ground, it’s hard to argue against giving the people a choice.

Last week in the Capital Markets
It seems amazing: one week ago, Russian troops effectively overran and occupied Ukraine’s Crimean peninsula…and markets ended the week acting as if better economic data was the more important development.

  • Currencies: The euro was up 0.4% against the dollar on the week, touching a 2-year high mid-week. Traders who had bet the European Central Bank (ECB) would ease lost money. The yen weakened, falling 1.5% against the dollar … seems to reflect a combination of less “safe haven” demand and expectations of further government actions.
  • Bonds: There was no flight to safety – U.S. rates rose on better economic data: the 10-year Treasury yield rose 14 basis points (bps) to 2.80%; the 10-year TIP yield rose 8bps to 0.57%. High yield spreads tightened another 2 bps to 379%.
  • Equities: For the week, The S&P 500 Index was up 1%. Within the S&P 500, financials (+3% on money center bank strength) led; industrials and materials were also strong. Utilities (-1%) trailed; health care (biotechs) and energy were also laggards. The MSCI Europe Index was volatile, reflecting the evolving Ukraine situation, but it ended up down only 1%. The MSCI Japan Index (+2%) rallied as the yen weakened. Emerging markets were flat
  • Commodities: WTI oil and gold ended the week with little change.

U.S. Economy: Weather Still Clouds the Picture, but Optimism Remains
The weather is not just a whiner’s excuse for a sluggish economy: the South Atlantic has gotten the most snow in over 30 years and New England the most in 20. The Fed Beige Book cites both significant weather drags and underlying strength. While there are incongruities in the data – i.e., pockets of strength and weakness that seem to run counter to the overall “weather” hypothesis – the mosaic of data still points to strength. The basic message of the ISM and Markit PMIs, for example, is: headwinds for now, but good prospects.

  • Both the Markit (57.1) and ISM (53.2) manufacturing PMIs were better than expected: weather held back production but new orders were strong.
  • Construction spending ticked up 0.1% month over month (m/m). Complain all you want about the weather: it is still up 9.3% year over year (y/y), largely due to the recovery in homebuilding activity.
  • Factory orders were relatively weak, suggesting that business is flat at best; partly due to weather, to be sure, but still weak.
  • Employment: a solid monthly jobs report, a benign unemployment claims report.
  • Consumers (or lenders) remain cautious about borrowing; student loans are the exception. Credit card debt dropped back m/m…the trend remains sideways. Auto loans ticked up (but, as noted, auto sales are trending sideways). Only student loans are showing a strong growth trend.
  • Inflation remains quiet: no sign of a wage-price spiral.

Eurozone data: Still Signaling a Slow Recovery and ECB Inaction

  • Q4 GDP (second estimate) growth was 0.3% quarter over quarter (q/q) and 0.5% y/y. Exports were strong; domestic demand was subdued.
  • The February Eurozone manufacturing PMI was 53.2, with above-50 readings everywhere except France (where it is rising toward 50). New orders and backlogs were stronger than employment – this suggests strength should continue.
  • German January industrial production was notably strong.
  • The ECB’s latest economic forecast is for CPI inflation of 1.0% in 2014, 1.3% in 2015 and 1.5% in 2016…if correct, the ECB won’t tighten policy at any point in the foreseeable future.
  • The ECB forecasts that GDP growth will be slow, at 1.2%, 1.5%, and 1.8% in 2014/5/6 – but remember, its mandate does not include economic growth or (un)employment: the sole mandate is “inflation close to but below 2%.” Despite slow expected growth, the projected trend of slowly rising inflation puts little pressure on the ECB to ease further now.
  • As a sidebar, ECB chairman Mario Draghi said the euro’s rise in the course of the past year had knocked nearly half a percentage point off the inflation rate. This is, in essence, the deflationary pressure exported to Europe by the efforts the U.S. and Japan to boost their inflation rates by depreciating their currencies.

Bitcoin: Adding Insult to Injury (The Patient’s Already Mortally Wounded)
The Japanese government said it plans to regulate bitcoin as a commodity (not a currency). Securities firms will not be allowed to broker bitcoin trades, and banks won’t be permitted to handle bitcoins, but the government will tax bitcoin transactions.

I suspect the final post-mortem on bitcoin is likely to show that it was a massive pump-and-dump operation: a shadowy person/consortium created a “virtual currency” which attracted almost a billion dollars of real money, several hundred million of which was then siphoned off (stolen) through a software “bug”.

Data Sources: The Wall Street Journal, Financial Times, Bloomberg

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About Sam Wardwell

Sam Wardwell, CFA, is Senior Vice President and Investment Strategist at Pioneer Investments. He joined Pioneer in 2003.
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