Markets are Unfazed as War Risks Escalate

The Capital Markets Were Very Calm Last Week, Considering The Rising War Risks

  • Equities:  After three strong weeks, the S&P 500 ended the week down 0.7%.  Higher oil prices boosted the index’s Energy sector to a 1.7% return; while all other index sectors declined.  MSCI Europe touched six-year highs mid-week but also ended down slightly less than 1%; MSCI Japan and Emerging Markets were up slightly.
  • Bonds:  The 10-year Treasury’s yield ended unchanged at 2.60%; the 10-year TIP yield rose 1 basis point (bp) to 0.41%.  The BoA Merrill Lynch High Yield index touched new cycle lows mid-week, ending 5 bps tighter at 3.47%.  European bond markets were calm.
  • Commodities: WTI was up $4.10 for the week, to $106.87 on war fears (Iraq is OPEC’s second-largest producer).  Gold was up about 2%.
  • Currencies:  The Chinese yuan and Japanese yen each rose about 0.5% against the dollar; the euro was down almost 1%.

A Black Swan Emerges In Iraq

A week ago, ISIS (Islamic State in Iraq and Syria) in Iraq was off the radar of the news media and market strategists.  It has suddenly emerged from the northwest of Iraq, which borders Syria, as a significant threat to the global economy (higher risk of a recession-causing an oil price spike). ISIS, a non-state Sunni militia and major player in the Syrian civil war, turned east (from Damascus to Baghdad), capturing several key Iraqi cities including Mosul, the nation’s second-largest. The Iraqi army apparently collapsed; Baghdad itself is perceived as threatened. 

  • ISIS’s goal is apparently to set up a strictly Islamic state; it is considered a terrorist organization by the U.S.
  • A disruption in Iraqi oil exports could cause a price spike which pushes the global economy into recession.  It’s not an immediate threat, though, unless the Iraqi army and government fail: ISIS is in the northwest; the oil is in the south.
  • This may also erupt into a long-feared Sunni-Shiite religious war: Grand Ayatollah Ali Sistani, one of the most senior Shiite religious leaders, called on Shiite civilians to join the defense of Iraq from ISIS.
  • War makes strange bedfellows: Iran and the U.S. are united in coming to Iraq’s aid…though Obama has already limited the extent of U.S. aid (no boots on the ground).

The Fighting Escalates In Ukraine                                 

  • The separatists apparently shot down a Ukrainian military transport plane killing 49.
  • NATO asserted it had proof Russia has provided the separatists with tanks.

Meanwhile, U.S. and Global Economic News Continued On Their (Moderately) Positive Trends

More “goldilocks” U.S. labor market data: solid employment growth without a “war for talent” putting upward pressure on wages.

  • The Job Openings and Labor Turnover Survey report showed the number of job openings jumping to 4.455 million, a new cycle high.
  • The Quit rate (number of quits during the entire month) was stable.
  • Unemployment claims ticked up slightly, to 317k.  Fine.

Retail Sales Were Stronger Than The Headline Suggested

  • Motor vehicle sales were strong. Ex-motor vehicles sales rose only 0.1% month over month (m/m)…which seems disappointing…but April was revised up by 0.4%, making May actually a pretty strong month—effectively a 0.5% increase.  This bodes well for second quarter gross domestic product (GDP).

Some Other Positive Signals                          

  • The National Federation of Independent Business Small Business Optimism Index jumped from 95.2 to 96.6 in May, a new cycle high.
  • Inventories grew…as did sales; the inventory:sales ratio remains moderate.  This is good.
  • Mortgage applications rose about 10% week over week (w/w).

More Inflation Data…No Problem

  • On a seasonally adjusted year-ago basis, May “Producers Price Index (PPI) Final Demand” (a new series which replaced the old PPI) was up 2.0% year over year (y/y) both with and without food & energy and with and without seasonal adjustments.
  • Import prices were up 0.4% y/y; export prices were up 0.5%.

Global Economic Growth Sees Positive Signals

  • The World Bank cut its 2014 global growth forecast from 3.2% to 2.8%, citing the harsh U.S. winter (its U.S. forecast was cut from 2.8% to 2.1%) and impact of the Ukraine crisis on the Russian economy.
  • China’s exports rose more than forecast (up 7% y/y).  This is considered an important signal that the global economy is OK.
  • The Chinese central bank eased slightly; inflation (Consumer Price Index 2.5% y/y, PPI 1.4% y/y) was fine.  Other data (fixed investment, industrial output, retail sales) were solid.
  • Japanese Q1 GDP was stronger than expected, even taking into account the expected pull-forward of demand by the tax rate increase.
  • European Monetary Union industrial production rose 0.8% in April (after a -0.4% March decline).  It’s up 1.4% y/y.

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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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