Global Stocks Open 2016 In Retreat: Are Geopolitical Worries To Blame?

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Includes: DIA, IWM, QQQ, SPY
by: Global Risk Insights

After one of their worst opening weeks in history to start the New Year, world markets are searching for answers among geopolitical events; from North Korean nuclear tests, to Saudi-Iran tensions, to tripped Chinese circuit breakers and emerging market economic worries. But root causes for recent volatility could point West – and there is likely more to come.

Happy new year

Two days into the New Year Iranian protesters ransacked the Saudi Arabian embassy in Tehran in a geopolitical response to the Kingdom’s execution of a prominent Shia cleric.

In response, Saudi Arabia severed diplomatic ties with the Iranian regime and gave their ambassadors 48 hours to leave the country. The Kingdom's Sunni allies followed suit to varying degrees as Iran attempted to temper the situation.

The sudden and dramatic escalation of the Iran/Saudi conflict put oil markets in focus as investors considered potential outcomes entering the first trading week of 2016.

As Monday came, it brought additional worries in the form of weak manufacturing data out of China. Chinese markets dropped nearly 7%, triggering exchange ‘circuit breakers’ that halted trading and elevated investor fear.

Oil mysteriously continued its persistent slide, despite facing a potentially explosive conflict in the Middle East, as world growth concerns led European and American stock indices dramatically lower.

Just two days later, news broke that North Korea claimed it tested a hydrogen bomb and capital markets moved even lower.

On Thursday, Chinese shares again stumbled out of the gate, falling another 7% and again triggering an all-day halt to trading. This time it was the Chinese central bank’s adjustment of the yuan that induced fears of mounting trouble in the world’s second largest economy. Shares around the globe continued the now unprecedented slide.

A brief respite from further breaking news on Friday did little to quell the fervor, it seems, as major markets in the U.S and Europe broke to new lows by the ringing of the first week’s closing bell. U.S markets dropped nearly 7%, European Bourses even more in what was one of the worst, if not the worst, starting week in history for global stock indices.

Correlation is not causation

Although the media and pundits quickly postulated that the significant Western market weakness was a direct result of China and heightened geopolitical concerns, it is important to analyze the true nature of these market declines to examine just how impetuous investors’ actions were.

Event driven market crashes are typically marked by an undeniable quality of panic. One does not have to look far for an example: On August 24, 2015, US markets experienced what could be considered the epitome of panic as the Dow Jones Industrial Average fell more than 1,000 points nearly straight down from the opening bell. However, the Dow erased at least half the loss by the end of the day and recouped the entire loss by the end of that week.

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Geopolitical impact on the markets?

By its very nature, panic tends to be overdone. As a result, such overreactions are typically met with a moment of capitulation in which the momentum reverses, if only temporarily. U.S markets followed this panic pattern in August, but the recent weakness tells a different story.

U.S. markets in particular, the largest and most influential capital markets in the world, displayed a surprisingly methodical retreat despite the sense of alarm raised by breaking world events. Though the week ended in a sea of red, there was no evidence of intra-day panic selling or the related snapback rallies indicating the selling was overdone.

Instead, it resembled a steady and systematic reduction of risk by investors that is not emblematic of spontaneous, outsized reactions to surprise geopolitical or economic events.

Can't see the forest from the trees

As Western investors and analysts look towards the East as the source of recent woes, they may be blinding themselves to the bigger picture. Slowing Chinese growth and increasing geopolitical risk are likely mere symptoms of a worldwide contraction in demand and uncomfortable truths concerning the true state of Western economies.

The incessant decline in the price of oil is perhaps the best indicator of this. While most attention has been paid to the oversupply of crude oil as the cause for the imbalance, it becomes clearer every day that supply reductions may fail to provide equilibrium due to fragile or falling demand.

Even the threat of major conflict between the Middle East's two most powerful oil producing nations was not enough to reverse the slide in prices.

Further, Chinese exports have been contracting even though its biggest trading partner, the United States, has a surging currency that should enable it to import more, not less. So perhaps the market's horrible start to the year should not be attributed to the second largest economy in the world; but instead to the first.

At the end of 2015, the U.S Federal Reserve raised interest rates for the first time in nearly a decade in spite of myriad domestic and global caution flags that economies were weakening. Even though U.S markets briefly spiked on the much anticipated announcement, they quickly faded and as of this writing have now fallen 10% from those levels.

The tightening by the world’s largest central bank may have added to deflationary forces, as feared, just when those forces are gaining momentum. CSX, the third largest railroad in the U.S by market cap, disappointed investors this week by missing earnings estimates and citing “negative global and industrial trends.” The earnings and revenues of this economic bellwether actually declined year over year.

Unfortunately, CSX is not alone as the estimated earnings growth of the whole S&P 500 for the fourth quarter of 2015 stands at negative 5.3%. Such a decline would be the third quarter in a row of earnings contractions, the first time that has happened since the first three quarters of 2009 – the worst stretch of the Great Recession.

In fact, the worst earnings momentum globally is not found in China or other emerging markets, it’s found in the world’s largest and most influential economy. The litany of news events last week may have merely served as a catalyst for fund managers to adjust to this new reality.

Conclusion

World markets are vulnerable to geopolitical events insomuch as those events force investors to take stock of underlying economic realities. For years the extremely accommodating policies of the Federal Reserve and other central banks numbed markets to such pains, but now that those policies are slowing or reversing, major markets will experience withdrawal symptoms just as the underlying disease is worsening.

Markets will likely bounce over the coming weeks, but underlying causes are unlikely to abate anytime soon. If the Federal Reserve continues their tightening policy as forecast, with two to three more raises in 2016, it will make matters exponentially worse. Therein lies the biggest political risk for investors – that notwithstanding clear and growing signs of economic weakness the Fed pushes forward with raising rates and hastens a global crunch that induces true panic reminiscent of 2008/2009.