Markets, already nervous about the forthcoming QE3 taper, reacted strongly last night to the growing momentum towards a military strike against Syria. Wall Street stocks fell hard, gold went up $US23, making it $US200 since late June, and crude oil futures spiked 3 per cent.
Behind the good performance of stocks over the past year is the fact that US Fed stimulus plus gradual economic stabilisation and relative geopolitical calm have allowed valuations to expand dramatically.
Strategist Gerard Minack pointed out this week that global stock markets have gone up 29 per cent from November 2012 to this month with no increase in either trailing or forecast earnings per share – it was driven primarily by an expansion in the American PE ratio.
With valuations stretched, markets are pricing that everything will go right, which is, of course, the time when things go wrong.
At the Australian Leadership Retreat on Hayman Island over the weekend we learned that the civil war in Syria is, in part, a proxy for two other layers of conflict: between Saudi Arabia and Iran and between the United States and Russia.
Middle-east experts at the Retreat also pointed out that civil wars never end in negotiation; someone has to win or else the country is partitioned. The consensus at Hayman was that Syria is most likely to be partitioned, although the apparent use of chemical weapons on civilians by the Assad regime may have tipped the balance towards US military intervention and an eventual Assad defeat.
Momentum is building inexorably towards a US strike against Assad – probably cruise missiles launched from American warships on specific Syrian military targets. Reports this morning suggest that the only thing stopping it is the need for a vote in the UK parliament. After that vote is finished on Thursday night (Friday morning out time) the air strikes could start at any time.
If it wasn’t for the players standing behind Assad and the Syrian rebels – Saudi Arabia and Iran; US and Russia – markets would not be greatly affected. After all, Syria is only a small oil producer.
But the fact is that this vicious civil war is, in part at least, a proxy war between much more significant players, and the appalling use of chemical weapons against civilians, almost certainly by President Assad, has ended the hands-off approach of the West and destabilised the broader impact.
So far the stock market has not been affected by the gloom enveloping the bond market. As the US 10-year bond yield rose from 1.6 to nearly 3 per cent between November and late July, equating to a fall in price of more than 10 per cent, the S&P 500 index rose 25 per cent.
But the oil price has now gone up 15 per cent since mid April and Brent crude is back above $US114 a barrel.
Beyond that, with stretched valuations investors are likely to focus on the broader negatives, which is why a column by Pimco’s Mohamed El-Erian this morning discussing the coming fifth anniversary of the Lehman Brothers collapse is getting some attention.
El-Erian identifies four concerns:
1. Western economies are still having trouble generating economic growth. “Five years after the global financial crisis, too many countries are being held back by exhausted and out-dated growth engines.”
2. There is a “large and persistent imbalance between the hyperactivity of central banks and the frustrating passivity of other policymakers.”
3. Developing countries have “slipped into an unbalanced policy mix that now threatens their continued growth and financial stability.”
4. Those who caused the crisis in the first place – the banks – have not been forced to change their ways. “Given their systemic importance, many (banks) were bailed out and, with continued official support, returned to profitability quite quickly. Yet they were not subject to windfall profit taxation, nor have policymakers sufficiently altered structural incentives that encourage excessive risk-taking. In the case of Europe, only now are banks being pushed to deal decisively with their capital shortfalls, leverage problems, and residual weak assets.”
And, he might have added, tensions in the Middle East have not subsided.