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Geopolitical Crises Are Buying Opportunities for Stock Investors

Geopolitical Crises Are Buying Opportunities for Stock Investors
(Dollar Photo Club)

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Monday, 07 August 2017 03:17 PM Current | Bio | Archive

In the past, I’ve frequently noted that geopolitical crises since the start of the 1960s have often created buying opportunities for stock investors (Fig. 1). Stocks would sell off quickly and sometimes sharply for a brief period, then rebound when the crises passed.

The two major exceptions were the oil price shocks of 1973 and 1979, which triggered severe recessions as US consumers retrenched in the face of soaring gasoline prices, which boosted inflation, forcing the Federal Reserve to raise interest rates significantly (Fig. 2).

In recent meetings with our accounts in the Mid-Atlantic states, I found that they all were fully invested in stocks and believed that the bull market could last for quite some time longer. Based on the S&P 500, on April 11, it became the second-longest bull market since the data started in 1928 (Fig. 3). On June 29, 2021, it would be the longest on record, if the bull continues to charge ahead that long.

In the past, the bulls were tripped up by recessions. The investors I’ve met with recently are all hard-pressed to see what might cause the next recession anytime soon. A geopolitical crisis is not on their worry list. When they asked me for my opinion, I noted that Debbie and I started to predict back on October 27, 2014 that the expansion could be one of the longest on record, and we still think so. It is currently the third longest since the end of WWII. In May 2018, it would become the second-longest expansion and in July 2019 the longest, if it lasts so long (Fig. 4).

Barring a major geopolitical crisis, if there is trouble ahead for the stock market, it might be internally generated. The bulls could get too cocky, continuing to pour money into equity exchange-traded funds (ETFs), setting new records for 12-month net inflows over the rest of this year and into next year. They have been doing just that since January, as we discussed last week (Fig. 5). That could cause a P/E-led melt-up, especially given the extraordinary complacency, as evidenced by the record-low readings for the S&P 500 VIX recently around 10.0, with Investors Intelligence reporting that only 16.2% of their respondents were bearish last week (Fig. 6).

Based on the record inflows continuing into ETFs and widespread complacency, Joe and I raised the odds of a Melt-Up scenario last week from 40% to 50%, while lowering the odds of a Nirvana scenario to 30% from 40%. We left the Meltdown scenario at 20%. But we will have to raise it, taking points away from the Melt-Up, if stocks do go into orbit first.

The Melt-up/Meltdown tag team could set the bull up for a nasty fall. However, that would not necessarily cause a recession. So it might very well be like 1987 all over again, with a fast and furious bear market setting the stage for a resumption of the secular bull market, as earnings should continue to move higher if the economic expansion continues to set records and maybe break the record for the longest run.

In my conversions with our accounts, we all seemed to agree that this may be the most obvious and plausible outlook for stocks and the economy. But surely, it can’t be that simple? What about geopolitical risk?

Before we go there, let’s consider domestic politics first. Then again, why bother when the stock market seems to be disinterested and totally tuning out all the melodrama? After all, the checks-and-balances system is working just as our Founders designed it to work; it is causing gridlock so that extremist policy initiatives on both sides of the aisle are stymied. Investors seem to agree with my long-held view: “Look how well our economy is doing despite all the meddlers in Washington!” Consider the following recent developments:

(1) Various indicators. The Citigroup Economic Surprise Index has rebounded from this year’s low of -78.6 on June 16 to -40.8 on Friday (Fig. 7). Earlier this year, this was a widely followed indicator because it suggested that US economic growth might be slowing more than anyone expected. Turns out that real GDP rose 2.6% (saar) during Q2, well outpacing Q1’s lackluster gain of 1.2%. On a y/y basis, real GDP growth continues to hover around 2.0%, as it has since mid-2010.

Another weak indicator earlier this year was commercial and industrial, or C&I, loans at commercial banks (Fig. 8). The growth rate of this series definitely has slowed so far this year, but it remains in record-high territory.

Inflation-adjusted exports rose to a record high during June (Fig. 9). Imports also edged up and are just below January’s record high. Incredibly, US exports of crude oil and petroleum products rose to a record 5.9mbd during the four-week period through January 6 of this year, up from a low of 0.8mbd during late 2005 (Fig. 10). Net imports of this category is down to 4.5mbd currently from a record high of about 13.0mbd during 2005. Frackers continue to make America a great oil producer again.

(2) Employment & wages. As we do every month, Debbie and I go straight to the bottom line of the monthly employment report. Friday’s data for July showed that the Earned Income Proxy (EIP) for private-sector wages and salaries rose 0.5% m/m and 4.6% y/y (Fig. 11). Our proxy was tracking wages and salaries very closely until mid-2016, but has been stronger than wages and salaries since then. Our hunch is that the latter variable could be revised higher substantially.

While wage inflation remained subdued at 2.5% y/y during July, as Debbie discusses below, it has been outpacing price inflation. As a result, real average hourly earnings (using the PCE deflator) rose to another record high in June (Fig. 12). This measure of purchasing power (and the standard of living) is up 0.9% y/y, 5.7% since January 2009, and 17.4% since January 2000. In other words, the notion that wages have been stagnating for several years is a HUGE myth.

Geopolitics: Bay of a Pig. Now let’s consider geopolitical risk. President Donald Trump and his agenda are sinking in the swamp of domestic politics. He seems to score more points when he goes abroad, such as when he lobbed some cruise missiles into Syria on April 7, when he met with leaders in the Middle East and Europe during May, and when he gave his praiseworthy Western Civ speech in Warsaw on July 6. When he met with President Barack Obama on November 10 last year, the outgoing president told his successor that his number one geopolitical challenge would be posed by North Korea’s nuclear missile ambitions.

Sure enough, North Korea conducted its second ICBM test a week ago Friday in what it called a warning to the “beast-like US imperialists.” It came less than a month after its first test, on July 4. This could develop into a geopolitical crisis that could have a bearish impact on the stock market, though more likely triggering a correction and a buying opportunity rather than a bear market. Consider the following:

(1) US Secretary of State Rex Tillerson hit back on Saturday, July 29, describing North Korea’s launch as a “blatant violation” of multiple UN Security Council resolutions. He also blamed Beijing and Moscow: “As the principal economic enablers of North Korea’s nuclear weapon and ballistic missile development program, China and Russia bear unique and special responsibility for this growing threat to regional and global stability.”

(2) This past Saturday, Trump’s National Security Adviser H.R. McMaster said in an interview with MSNBC that the US is preparing for all options to counter the growing threat from North Korea, including launching a “preventive war.”

(3) A week ago Sunday, the US conducted a test of its Terminal High Altitude Area Defense (THAAD) defense system in Alaska by launching a ballistic missile over the Pacific Ocean. The weapon was fired by a US Air Force plane and intercepted by the system, the Missile Defense Agency (MDA) said, describing the test as “successful.”

THAAD is designed as a “bullet to hit a bullet.” It carries no warhead, relying on its kinetic energy to destroy an enemy’s incoming missile. That’s to reduce the chances of exploding a conventional warhead or detonating a nuclear one. The system is designed, built, and integrated by Lockheed Martin Space Systems, acting as prime contractor. Key subcontractors include Raytheon, Boeing, Aerojet Rocketdyne, Honeywell, BAE Systems, Oshkosh Defense, MiltonCAT, and the Oliver Capital Consortium.

(4) China's state-owned Xinhua news agency blasted the South Korean government on Friday over its decision to deploy additional THAAD launchers. The Chinese are convinced that the system’s very sophisticated radar will be used to track missiles launched from China. That’s a fear that Trump could heighten for the Chinese by convincing Japan to install a THAAD system, in an effort to pressure the Chinese to stop the North Koreans.

(5) On Saturday, the UN Security Council passed a resolution imposing new sanctions on North Korea. It targets the country's primary exports, including coal, iron, iron ore, lead, lead ore, and seafood. Also targeted are other revenue sources, such as banks and joint ventures with foreign companies. The sanctions will slash North Korea's annual export revenue of $3 billion by more than a third, according to a statement from the office of Nikki Haley, the US ambassador to the UN. Though it’s doubtful, let’s hope the sanction approach works.

(6) This rapidly evolving crisis remains under the stock market’s radar screen for now. In many ways, it reminds me of the Cuban Missile Crisis during October 1962. Emboldened by America’s botched April 17, 1961 Bay of Pigs fiasco, aimed at toppling Fidel Castro, Soviet leader Nikita Khrushchev put nuclear missiles in Cuba. President John Kennedy called his bluff by imposing a naval blockade around the island nation. Khrushchev blinked and withdrew the weapons.

This time, the US is moving antimissile systems close to China, not only to defend against North Korean missiles but also to spur the Chinese to get rid of North Korean leader Kim Jong Un, who is certainly cruel and dangerous and probably crazy too. The deal: Make Kim go away, and we won’t deploy THAAD.

(7) If China fails to make the deal, then the US might very well use THAAD to shoot down a North Korean missile test. That would certainly get everyone’s attention, including complacent stock investors’. It would also unambiguously resolve the question about Kim’s sanity. If he does nothing to retaliate other than to kick and scream, he is sane. If he attacks South Korea with an artillery barrage, he is insane.

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.

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EdwardYardeni
I’ve frequently noted that geopolitical crises since the start of the 1960s have often created buying opportunities for stock investors.
geopolitical, crisis, buying, stock, investors
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2017-17-07
Monday, 07 August 2017 03:17 PM
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