Geopolitics Trumped Economics in Last Week’s Capital Markets

Observations on the Capital Markets – Week Ended August 8, 2014

Ukraine developments, more than economic news, seemed to drive the day-to-day pattern of market returns.  Russia first massed troops on the border, prompting NATO to warn of imminent invasion risks, then sent them back to their barracks, keying Friday’s rally.  The conflict is far from over.

Developments in Gaza (a brief cease-fire) and Iraq—where Obama (reluctantly, it seems) authorized airstrikes against ISIS, leaving both domestic hawks and doves feeling unsatisfied—also made the front page, while central banks in Europe, England, Japan, Australia, and India all left policy essentially unchanged—not front page news.  The global composite Purchasing Managers Index (PMI) made a new 9-year high in July at 55.5 ‑ but with war risks high, no one paid much attention.        

There wasn’t much U.S. economic data, but it pointed at future strength, and an upward revision to Q2 GDP.

  • Factory orders rose 1.1% month over month (m/m) (3.0% year over year (y/y)), above consensus.
  • The ISM non-manufacturing (services) index rose from 56.0 to 58.7, boosted by new orders (64.9) and employment (56.0).  This is the index’s 54th consecutive month above 50, which indicates expansion, and a new cycle high.
  • June’s trade deficit was far enough below the assumptions embedded in the advance estimate of Q2 GDP to adjust it in the next release.  Imports fell 1.2%, while exports rose 0.1%.
  • Initial unemployment claims fell to 289k.  The four-week average fell from 298K to 294K, another recovery-to-date low and the lowest since February 2006.
  • The average price of regular gasoline declined for the fifth consecutive week and is down 3% y/y.

Europe: war fears are holding back the economic recovery.

  • A rise in the Markit Eurozone non-manufacturing PMI to 54.2 boosted the Eurozone (EZ) composite Purchasing Managers Index to 53.8, a 3-month high (manufacturing came in at 51.8 last week).  Spain (56.2) was a positive surprise; Italy (52.8) disappointed.
  • German factory orders fell again, -3.2% m/m (month over month) and -2.4% y/y.  Industrial production rose 0.3% m/m but is down 0.5% y/y.
  • Italian “flash” GDP declined for the second quarter in a row (-0.1% in q1 after -0.2% in q2), the 11th decline in 12 quarters, but real GDP is down only 0.3% y/y.
  • The EZ June unemployment rate dropped from 11.6% to 11.5%.
  • The European Central Bank (ECB) quarterly Bank Lending Survey showed banks easing credit standards on business loans for the first time in seven years.

“This is going to hurt me more than it hurts you.”  Really?  Believe it.

  • Russia (which imports 43% of its food) announced retaliatory sanctions against the West, barring food imports from countries that had imposed sanctions on Russia (the EU, Ukraine, Australia, the U.S., Norway, and Canada).

Russia Trade BansIn the Markets:


  • US Equities: The S&P 500 ended the week up 0.3%.  Telecom (-2%) and Health Care (-1%) lagged.   Consumer Discretionary (+1%) led, closely followed by Materials, Consumer Staples, Energy, Industrials, and Financials.
  • International Equities: Across the MSCI indices‑Europe was down 2%.  Portugal (bank failure) and Greece (no relief from austerity) led on the downside.  Japan was down 4% . . . but that’s a misleading number since Japan closed before the US rallied Friday.  Emerging Markets were was down about 1%, but again, Asian markets closed before the US rally.
  • Corporate Bonds: Lipper said redemptions from high yield bond funds in the week ending Wednesday were the largest on record, capping a 4-week string of outflows.  Still, after rising 50bps last week, the yield spread of the BoAML High Yield Index fell 5 bps to 4.20%. Finding a bottom?
  • Government Bonds: 10-year Treasury yields touched 2.35%, ending the week down 8 bps at 2.44%. Soft Eurozone data and a flight to safety in Europe drove German 10-year yields down 8bps to 1.05% and German 2-year yield went negative briefly; Japanese 10-year bonds fell slightly, to 0.51%.
  • Commodities: Oil ended essentially flat at $98 as expectations of soft demand growth and strong supply growth continue to offset Mideast war/supply shock fears.  Gold was up about $18 to $1310.  The overall Global Commodities index broke lower, suggesting weak demand.
  • Currencies: The dollar ended up 0.1% against the Euro, down 0.5% against the Yen.  The Chinese yuan rose every day last week, ending up 0.4% against the dollar, supported by signals that the Peoples Bank of China will keep liquidity tight.


Banks are more willing to lend . . . but they’re competing for scarce business.

  • The Fed’s Senior Loan Officer Opinion Survey showed banks easing credit standards, most notably for residential mortgages.
  • Mortgage applications ticked up marginally w/w but remain down double-digits y/y.
  • Consumer debt rose in June, but revolving (credit card and line of credit) debt rose only fractionally.  Consumers are borrowing the finance purchase of capital assets (homes, cars, and education) but aren’t spending next month’s paycheck this month.
  • This should help: FICO credit scores are being “recalibrated.” Lots of people will get higher scores.  That will encourage banks to lend (rightly or wrongly) to consumers they previously deemed too risky.

Don’t put too much weight on the labor productivity and unit labor cost data: they were distorted by the volatility in reported GDP.

  • Labor productivity is, over time, the key to economic growth (the wealth of nations) and unit labor costs are a key inflation driver, but both are calculated as “residuals” of GDP and labor compensation.  The exaggerated volatility in reported GDP makes q/q comparisons effectively meaningless.  I think the weather was a drag in Q1, but still find it hard to believe the economy really shrank 2% (annualized) even as businesses steadily increased hiring and cut layoffs rose.   Did ULC really rise at an 11.8% annual rate in Q1, then only at a 0.6% pace in Q2.  Did labor productivity really fall 4.5% (annualized) in Q1 then rise at a 2.5% pace in Q2?  The data is just too noisy.
  • Over the past year (smaller distortions), output rose 3.2%; productivity was up 1.2% and ULC was up 1.9%.
  • With that said, unit labor costs (ULCs) appear to be trending up: a year ago, y/y ULC was 1.0%.

The ECB met, didn’t change policy, but continued to sound dovish. 

  • The ECB statement added “uneven” to the description of the recovery and “heightened” to geopolitical risks but did not say that downside risks had risen.
  • Draghi downplayed the decline of headline inflation to 0.4% y/y, noting that core has been stable at 0.8%.  (Comment: I completely agree…their focus should be on Core, not Headline CPI.  Rising food and/or energy prices reduce demand for other things; if a central bank reacts to those prices, its policy will be pro-cyclical, rather than countercyclical.)
  • Draghi said the ECB is “unanimously committed” to using unconventional policy more, if needed and is doing “intense preparatory work” to launch an asset-buying program (but of loan-backed, asset-backed securities, not of government bonds).  Comment: don’t lose sight of the fact that the ECB’s mandate all but prohibits its monetizing government debt or deficits via quantitative easing.

Japan: The BoJ met, didn’t change policy: it continues to expect a recovery and wait for “good” (i.e. wage) inflation.

  • The Bank of Japan’s central bankers left policy unchanged (no surprise), acknowledging current weakness but reiterating its upbeat outlook based on low unemployment and the expectation of rising pay.
  • Nominal wages were up 0.4% y/y in June.  In inflation-adjusted terms, they’ve fallen for 12 consecutive months and are down almost 4% y/y.

China data suggest weakness: rising trade surplus, lower house prices, weakening PMIs.

  • The trade surplus hit a record high in July: exports rose 14.5% y/y, imports fell 1.6% y/y. Exports to the US rose 12% y/y, to the EU 17%, and to Japan 3%.  The big surplus isn’t all good news: weak imports suggest domestic weakness.
  • The official (National Bureau of Statistics) nonmanufacturing PMI fell from 55 to 54.2 and the HSBC Services PMI fell from 53.1 to 50 in July.  Weaker real estate-linked activity (e.g. brokerage) was noted as a key drag.
  • Prices of new homes in China declined 0.8% m/m in July, their third straight monthly decline, according to the China Real Estate Index System’s 100-city house price survey.
  • July CPI was up 2.3% y/y.

S&P 500 earnings continue to surprise on the upside.

  • With over 90% of the S&P 500 having reported, earnings are still on track for +11% y/y earnings per share ($117/yr pace).

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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