To my clients:
If interested, some timely and relevant articles have now been posted to the Our Curated Library section of the site. More will follow in the weeks ahead.
It was a mixed week for North American stock markets with the Canadian TSX rising 1.3%; the U.S. Dow Jones Index falling 1.0%; and the U.S. S&P 500 falling 0.5%.
I have three items on the agenda for this week: the 0.25% rate cut in the U.S; implications of the attack on Saudi Arabian oil facilities; and a look at the U.S. labour market, with particular emphasis upon the continued positive trend in weekly jobless claims (the second most closely watched recessionary indicator here at RBC).
Starting with the widely anticipated 0.25% rate cut by the U.S. Federal Reserve on Wednesday, I must admit that the market reaction was more muted than I had expected. To paraphrase what I wrote last week, I was of the belief that the market would be disappointed by a mere 0.25% rate cut, and would be buoyed by a 0.50% rate cut. Since the Fed has traditionally only moved in increments of 0.25%, this left no room for a cut somewhere in the middle and led to my suggestion that any market response would be a material move in one direction or the other. Initially it seemed this might be the case as the Dow retreated some 200+ points in the half hour after the announcement. But then Chairman Jerome Powell held his press conference, and a steady recovery ensued the remainder of the day such that the U.S. indices were essentially flat at the close. Why was this? Well, I’d make the following couple of observations about the press conference:
- Chairman Powell continued to stress that neither he, nor the broader Federal Open Market Committee (FOMC) which he represents, felt that the U.S. economy was heading toward recession. Yes, global risks (notably trade concerns) had risen, but the continuing expectation was that the U.S. economy is strong enough to weather this soft patch; and
- Chairman Powell was very clear that the Fed was not on any pre-conceived path, and would continue to act as appropriate depending upon incoming data. While he has said this before in previous news conferences, this time the topic was a recurrent theme throughout the conference, and his delivery of the message was forceful. He asserted that this week’s 0.25% cut was an “insurance” cut in the face of global headwinds, but the FOMC would be prepared to act more vigorously if necessary. Specifically, he stated “if (incoming data were to indicate) the economy does turn down, then a more extensive sequence of rate cuts will be appropriate. We don’t see that. It’s not what we expect.” I believe it was this message, and variants of it delivered throughout the conference, that led to the market recovering off of its initial lows.
Moving on, as I’m sure all will know, there was an aerial attack on the oil infrastructure in Saudi Arabia last weekend, and up to 50% of the Kingdom’s oil production capacity was initially taken offline as a result. Moreover, this reduced capacity represents about 5% of global oil production. It remains unclear whether the attack was via drones; cruise missiles; or some combination of both. Houthi rebels based in Yemen claimed responsibility. Saudi Arabia has been trying to quash this rebellion in neighboring Yemen since 2015. Most analysts do not believe that the Houthi’s could have launched such an attack on their own, and further, that preliminary assessments of the direction of the attack suggested it was more likely to have originated in Iraq or Iran – not Yemen. Both Saudi Arabia and the U.S. have asserted that Iran was behind the attack. While Iran has denied responsibility, tensions in the region have risen, and the threat of military engagement – and possibly war – has risen materially. So again, these are the basic facts as I’m sure all will know. More germane from an investment perspective is what this may mean for the price of oil and, relatedly, the global economy and investment markets.
I’ll start with the economy first, and reassert a point I have made many times in the past. Nearly always it proves unwise to take defensive measures in investment portfolios on the basis of some flare-up in international tensions. RBC updated some recent research and noted an average decline of 6.3% in the S&P 500 during 26 previous acts of war or terrorism since the conclusion of World War II. Further, the average time taken to recover these declines was just 30 days (and as short as 3 days with the onset of war in Afghanistan in October 2001). There were four outliers to these averages with three being:
- a 14.9% decline and an 86 day recovery period for the start of the Cambodian Campaign during the Vietnam War in 1970;
- a 12.9% decline and a 56 day recovery period at the start of the Korean War in 1950; and
- a 15.9% decline and 131 day recovery period when Iraq invaded Kuwait in 1990.
But even with these first three noted outliers, I suspect most observers would have guessed that the declines would have been worse, and the recovery periods longer. But that’s not the case. Now of course, there is a final, fourth, outlier – the start of the Yom Kippur War and Arab Oil embargo beginning on October 6, 1973. Then the S&P 500 declined by 16.1%, and took 6 years to recover! Of course this is a significant outlier and would be the “yeah, but” counterargument to the other 22 identified instances of market declines in the face of geopolitical conflict. Yet this instance makes the case even more insofar as the 1973 decline coincided with recurrent recessionary conditions and economic stagnation prevalent during much of the 1970’s. Not to be flippant, and of course exceptions exist (i.e. World War II), but the point is that the temptation to ‘duck for cover’ in investment portfolios when bullets fly must be strongly resisted or, at least, be supported by macro-economic conditions that also support the temptation. It’s not inconceivable that now may be just such a time, but as I’ve argued repeatedly and consistently, that is not my or RBC’s base case at present. It’s not the U.S. Federal reserve’s either. We will, as always, continue to watch closely.
Quickly now to the price of oil itself - a commodity such as oil is inherently more volatile simply because it is not widely diversified in the way that a global economy is. So, geopolitical events such as the Saudi oilfield attacks can, and do, have an impact upon the price of the commodity. As our lead commodity analyst Helima Croft asserts, the oil market will now be forced to include a geopolitical risk premium in the price of oil for the long foreseeable future. Saudi Arabian vulnerability to such an attack was laid bare for the world to see. Practically, what this means is that whatever the equilibrium price (owing to traditional supply and demand factors) may have been in the period leading up to the attacks, one might now reasonably add another $3 to $5 per barrel to that price. Of course, this increased price will have some damping effects upon economic activity, but it is not – yet - a material concern. Perversely, Canada in particular might benefit in such a scenario. Is it coincidence that the Canadian market rose to an all-time high this week while the U.S. market modestly declined?
Lastly, and in support of the argument that imminent recession is not our base case scenario, is the current condition of the U.S. labour market. To put it bluntly, it is exceptionally strong. Depending upon the metric used to measure its health, it may be historically strong. Yet at this point I will concede a truism – recessions always begin soon after the unemployment rate reaches its cycle low. This may lead many to conclude that the labor market is, in fact, portending recession. We’d disagree. To illustrate why, I’d note that a year ago the unemployment rate was also at it cycle low, but it is lower now. The same could be said for 3 years ago, or 5 years ago, or 10. The point being is that the unemployment rate typically moves steadily lower (with minor fits and starts along the way) throughout an economic expansion. Identifying where the ultimate, and final, low in the rate might be is only obvious in hindsight. It is for this reason that RBC has identified the trend in weekly jobless claims as its second most important indicator of recession (and, some internal here at our firm suggest it might be better ranked as the most important indicator). The reason for this is that the trend in weekly jobless claims is, for lack of a better term, more “fidgety” than the employment rate, and ebbs and flows on a weekly basis. Our research has shown that a bottoming in jobless claims has reliably preceded the arrival of a U.S. recession, with the cycle low typically occurring several quarters before the recession’s onset. At present, claims are in the rough neighborhood of 200,000 per week. Given that this represents multi-generational lows in the metric, our back-of-the-envelope math suggests that claims would have to move into the neighborhood of 250,000 per week on a sustained basis for this indicator to begin causing pressing concern. The concluding graph linked below clearly shows how claims have moved higher ahead of recessions past, and how no such move higher currently exists.
That’s it for this week. All the best,
Nick Scholte, CIM, FCSI
Vice-President & Portfolio Manager
Scholte Wealth Management
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