For much of 2014, equities advanced despite disturbing world news headlines. However, that changed last week, as U.S. stocks slipped amid news of the escalating violence in Iraq.
Why the different stock market reaction? The events in Iraq pose a greater risk for markets than earlier 2014 geopolitical turmoil because there is a clear link between the conflict in Iraq and the global economy: energy prices.
As I write in my new weekly commentary, oil prices spiked last week as sectarian violence escalated in Iraq, a country producing more than 3 million barrels of oil per day, at a time when production has already been falling in many other parts of the Middle East, neutralizing the benefit of surging North American oil production. West Texas Intermediate (NYSE:WTI), the U.S. oil benchmark, traded above $107 per barrel, while Brent Crude, the global benchmark, hit approximately $114 per barrel.
While a short-term spike in oil prices due to declining production in northern Iraq is not a major threat, a prolonged price rise would put additional pressure on the global economy, including U.S. consumers, who are still operating in a mode of caution.
As of early this week, the violence in Iraq showed no sign of abating and it appeared that the crisis in the Middle East isn't likely to be resolved quickly.
Perhaps even more importantly, in addition to the short-term impact on oil production, the insurgency in Iraq and civil war in Syria have the potential to dramatically alter national boundaries in the Middle East.
In other words, there may be longer-term implications and potentially significant changes to international borders. Under this scenario, energy prices may remain elevated for a prolonged period of time, which could add additional pressure to several major economies, including the United States, China and India.
As for what this means for investors, higher oil prices, coupled with still reasonable valuations in the energy sector, support a continued overweight to energy stocks. At the same time, higher oil and gas prices represent yet another headwind for a U.S. consumer already struggling with slow wage growth and high personal debt. In a world of modest growth and a strapped consumer, I believe a cautious view toward consumer stocks is warranted.
Sources: BlackRock, Bloomberg.