Week Ahead: New Highs Look Possible, But Risks Remain
From an economic perspective, one thing dominated this weekend’s news: the missile strike on Saudi oil facilities. The early evidence is that the market is shrugging off the risks from that to America, or at least its economy. S&P 500 futures indicated a much lower opening but recovered much of that ground as the open approached. That is no surprise given the market mood right now, but eventually it is likely that the bounce, not the initial move, will look like the overreaction.
That mood is one of optimism, sparked by a run of encouraging news on the trade front. If you are a regular reader of Market Musings you will know that I noted a while ago that more and more frequently, encouraging news on trade seems to come after a market selloff. If you wish, you can say that that is a coincidence but even if it is, the material effects of more talks, or in this case a two-week delay in the imposition of the latest round of taxes, is very little. The underlying dispute remains, however, and talks have been ongoing for a long time without result.
Even so, traders seem to be looking for an excuse to buy, and even a brief, fairly meaningless pause in hostilities between the U.S. and China gives them just that.
Given the level of optimism, the muted reaction to the weekend’s news, and the domestic focus of equity traders, another attempt at record highs still looks to be on the cards this week. So far, though, each new high in this long upward run has been followed by a significant selloff, and this time will probably be no different.
It is as if the market becomes obsessed with hitting a new mark, but once that is achieved, the reality of the risks to global growth move back into focus. Those risks don’t just come from the trade war, either.
Brexit is still a mess. As an Englishman I am not proud to say it, but political maneuvering in the U.K. is making it look like a hard Brexit without any deal to soften the blow is the only logical conclusion as the chaos drags on. Even the U.K. government is quietly saying that that would be a disaster for the country, but it could also be the same for Europe. The ECB last week saw fit to cut rates even further and reinstitute QE as they believe it will have a potentially devastating, wide-reaching impact.
The global nature of those risks are presumably why U.S. equities remain strong despite them. America is still the world’s economic leader and a strong domestic economy can overcome a lot of problems elsewhere. If you see global economics as a bit of a zero-sum game it could even be argued that Chinese weakness and European chaos are beneficial for the U.S., but that hasn’t been the case over the last sixty years or so. I’m not sure why people think it has changed now.
That attitude also seems to have spilled over to the analysis of the attacks on the Saudi oil installations. Most of the early analysis is focused on to what extent higher oil prices will hurt the U.S., but that isn’t the point. Given that domestic production keeps increasing, higher oil prices will help the energy sector here, probably enough to offset the broad demand-damping effects.
There is, however, a much bigger threat than slower growth.
What this shows is just how easy it is for a localized dispute, in this case in Yemen, to spread in the Middle East. The Saudi’s, like the U.S., will blame Iran directly for this. That increases the risk that the proxy war being conducted between Saudi Arabia and Iran in Yemen and Syria escalates into open conflict. If that happens, it is hard to see how this administration, which has frequently voiced support for the Saudis, can remain neutral.
In other words, while the effects on the price of oil and growth shouldn’t be ignored, the real risk is of America getting sucked into another draining, destructive conflict in the Middle East. As the father of an American soldier, I hope to God that doesn’t happen, but even just a heightened fear of it will spook the market. The Saudi response to these attacks should therefore be watched very closely.
On balance, while new highs are distinctly possible this week, there are good reasons to believe that the pattern to date of a retracement once they are set will be repeated. That means that a strong rally early in the week should be seen as a selling opportunity, or at least a good time to hedge your portfolio.