Tuesday, June 24th, 2014

Desert Storm

Sometimes geo-politics is not nearly as dramatic as the television would have us believe, and sometimes the simplistic narrative does not fit very well with capital markets. The human cost of the ISIS invasion of Iraq is mounting by the day, but the impact on investment portfolios is strangely muted. So far there has been no evidence of a flight to the safety of the US dollar or Swiss Franc. US bond yields have risen slightly but so have US equities. This does not feel like 2002 or 1991. This is much more like the Crimea crisis early this year. After a brief wobble, asset prices settled down as investors realised that World War 3 was not about to break out.

The only lasting legacy of that “crisis” was that oil prices stopped trending downwards and started trending sideways. ISIS has now nudged the trend upwards, but it would have to continue on the same course for many weeks before it hit the highs of 2012 and 2011, let alone the level of 2008. This is not a geo-political crisis – at least not yet – but there has been a noticeable effect on sector allocation. The Energy sector is now ranked in the top three sectors in each region for the first time since April 2011. It is currently #1 in the UK, Japan and the US, #3 in the Eurozone and #2 in Pan-Europe. The last time that any sector was at the top in each region was Consumer Discretionary in November 2013.

However, the outperformance of Energy started well before ISIS invaded. In the UK, Energy has been making steady progress up the table all year, and joined the top three in early April, as investors switched into large-cap dividend paying stocks. In Japan, the sector also entered the top three in April, as investors searched for a way of reducing exposure to the domestic economy. In the Eurozone, which is the sector’s lowest ranking, the sector hit the top three in the middle of May, three weeks before the invasion. Only in the US is there a clear link between Iraq and Energy topping the rankings.

In the US there has always been a clear link between an increase in gasoline prices and a slowdown in the growth of retail sales, which normally operates with a lag of about three months. It is therefore no surprise to see Consumer Discretionary ranked #9. But it would be a mistake to extrapolate this pattern onto other regions. In the Eurozone it is traditionally Industrials which feels the impact of higher Energy prices and the sector has fallen from #4 to #7 in the last five weeks. (European excise duties on fuel are much higher so the link between crude oil prices and retail sales is much weaker). In Japan, it is Utilities which suffer because of the difficulty of maintaining margins if feed-stock prices rise, while selling prices are tightly regulated. Utilities have been #10 in Japan since November 2013. By contrast they are #1 in the Eurozone and #3 in the UK.

Conclusions: (1) ISIS / Iraq could turn into another geo-political crisis, but it hasn’t happened yet, which is why there is no impact on asset allocation. (2) Everywhere apart from the US, the strength of the Energy sector predates the ISIS invasion. (3) There may be unity at the top of the rankings, but there is none at the bottom. In each region a different sector is forced to absorb the selling pressure generated by the rise of Energy.

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