FINANCIAL REVIEW

Strange Days Indeed

Sinclair Noe — October 2, 2014

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Financial Review

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DOW – 3 = 16,801
SPX + 0.01 = 1946
NAS + 8 = 4430
10 YR YLD + .03 = 2.43%
OIL + .59 = 91.32
GOLD + 1.30 = 1215.30
SILV – .08 = 17.20

The Dow Industrial dropped about 130 points in early trading, but then recovered, mainly

In economic news:
The number of Americans filing new claims for unemployment benefits fell last week by 8,000 to a seasonally adjusted 287,000. Separate data showed small businesses hiring workers at the fastest pace in 8 months. The National Federation of Independent Business said its monthly survey of its members found they added an average of 0.24 workers per firm last month, on a seasonally adjusted basis. Tomorrow the government will report on non-farm payrolls for September; we’re looking for about 220,000 net new jobs and the unemployment rate to hold near 6.1%.

A report from the Commerce Department showed new orders for factory goods posted their biggest decline on record in August. Factory orders dropped 10.1%, following a 10.5% increase in July; the wild swings are attributed to orders for airplanes. Stripping out transportation orders, new orders were down a more modest 0.1%.

Since June, the European Central Bank has lowered the interest rate on bank deposits parked at the ECB to negative territory, a first for this central bank, and added new lending and private-asset purchase programs. Today, the ECB wrapped up a policy session and announced nothing new. They will wait and see if some of the stuff they’ve done in the past few months, will actually start to impact the Eurozone economy. They really can’t cut rates much lower, and there is only tepid demand for any kind of a lending program. They’ve already announced a plan to purchase collateralized bank bonds and bundles of loans known as asset backed securities, but that won’t start for about 2 weeks. So, for now, they sit back and wait and watch. Today’s ECB meeting was held in Naples; about 1,000 protesters were arrested.

You’ve already heard about the Liberian man who took a flight to the US and then came down with Ebola. He is in a Dallas Texas hospital fighting for his life. At first CDC officials thought there were just a handful of people possibly exposed, then they upped the number to 18, then about 40 people who would need to be monitored for possible Ebola infection. Now they say up to 100 people may have had direct or indirect contact with the patient. Dallas County officials said 12 to 18 people had direct contact with the Texas patient, and they in turn had contact with scores of others. If it sounds like a contagion, well it is. But the good news is that the health care system in the US should be more effective than the health care system in Western Africa. With the right care, people can survive an infection. Keep calm and carry on.

The New York Times reports a cyber-attack this summer on JPMorgan Chase compromised more than 76 million household accounts and seven million small-business accounts, making it among the largest corporate hacks ever discovered. In a regulatory filing, the bank said that the information leaked included names, email addresses, phone numbers and addresses. The bank said that there’s no evidence account information was taken. By the time JPMorgan first suspected the breach in late July, hackers had already gained the highest level of administrative privilege to more than 90 of the bank’s computer servers. And it appears the hackers made off with a list of the applications and programs that run on every standard JPMorgan computer, a hacker’s roadmap of sorts, which hackers could cross check with known vulnerabilities in each program and web application, in search of an entry point back into the bank’s systems.

Hong Kong has the sixth largest stock market in the world, which is second in Asia after Tokyo, and is the sixth largest hub for foreign exchange trading. It maintains open borders to investors and does not impose any capital controls.

Beijing’s man in Hong Kong, CY Leung has told pro-democracy protesters to step down, and repeated warnings that the consequences would be serious if they sought to surround or occupy government buildings, but he says he will not resign. Tens of thousands of people have taken to the streets in the last week to demand full democracy, including a free voting system when they come to choose a new leader in 2017. Now the protestors have surrounded at least 2 government buildings, including the building housing the Chief Executive CY Leung. It looks like the standoff is coming to a head. It will be an interesting weekend.

An International Red Cross building in eastern Ukraine was bombed and one worker was killed. Seven Ukrainian soldiers were killed in a single strike by tank fire on their armored personnel transporter on Monday. On Wednesday at least 10 people were killed when shelling hit a school playground in Donetsk. The Russian and Ukrainian governments say the ceasefire is holding; if so, it is just by a thread.

Turkey will join in the fight against ISIS; they also want to see Syrian President Assad removed from power. Turkey is already struggling with 1.5 million refugees from the Syrian war alone. It has now deployed tanks and armored vehicles on the border with Syria as fighting intensified and the parliament approved the measure to go to war. It is not clear whether Turkey will take immediate action, however the approval of the MPs could enable the US to use its large airbase in southern Turkey for air strikes against ISIS.

Of course ISIS has grown quickly, in part because they have taken over oil wells, but that raises the question of who has been buying oil from ISIS. The answer is smugglers, and they buy on the cheap. A barrel of oil that would ordinarily sell for over $90 can be discounted as much as 75 percent. But it’s still a profitable sale for ISIS, as the money it loses from such a discount is more than made up for by the readiness of customers to buy its oil and the plethora of routes through which it can export it.

Global oil prices have fallen to their lowest level in more than two years after Saudi Arabia cut its official selling price. Concerns of oversupply after higher output in the US, together with forecasts of lower global demand by the International Energy Agency, are driving prices down. But that just seems to highlight a most peculiar marketplace, especially in light of the geopolitical risks. Oil prices drop and stock markets are floating merrily along near record highs in the face of the Russia-Ukraine conflict, the emergence of ISIS and a new round of fighting in Iraq and Syria, mass protests in Hong Kong and China’s ongoing territorial disputes. And the cherry on top: credit markets show low spreads, while long-term bond yields have fallen in most advanced economies.

Strange days indeed. What gives?

Markets have taken the view that the Russia-Ukraine conflict will remain contained, rather than escalating into a full-scale war. The sanctions and counter-sanctions between the West and Russia have increased, but so far they are not causing significant economic and financial damage to the European Union or the US. Russia is feeling the pain of the sanctions, but that means they are likely to continue to supply natural-gas supplies to Western Europe.

The turmoil in the Middle East has not triggered a massive shock to oil supplies and prices like those that occurred in 70s. On the contrary, there is excess capacity in global oil markets. Iraq may be in trouble, but about 90% of its oil is produced in the south, near Basra, which is fully under Shia control, or in the north, under the control of the Kurds. Only about 10% is produced near Mosul, now under the control of ISIS. Yesterday, Saudi Arabia signaled to the markets that it was more interested in maintaining market share than in defending prices. Saudi Aramco, the national oil company, stunned markets by announcing that it was cutting prices by about $1 a barrel to Asia, the crucial growth market for the Persian Gulf producers, as well as by 40 cents a barrel to the United States.

The main source of supply growth continues to be the United States, which, as a result of the shale oil boom, now rivals Russia and Saudi Arabia in oil output. While the United States remains a modest oil exporter, its surging output pushes other oil, particularly from West Africa, out of the American market, helping to lower prices. Net oil imports to the United States have fallen since 2007 by 8.7 million barrels a day, roughly equivalent to total Saudi and Nigerian exports.

What could go wrong?

Well, the situation in Hong Kong could turn violent. Russia may break the ceasefire in Ukraine, or they might turn off the natural gas supplies with the first winter storm. The Eurozone could relapse. An ISIS jihadist could decide to leave the desert and try to wreak havoc on a major city. Toss in a sidebar story of turbulence in Thailand, or Argentina, or Turkey, or Egypt, or hackers doing great damage in the cyber-world, and you’ve got the makings of a brouhaha. You can’t rule out financial contagion, or any other kind of contagion.

One hundred years ago, the financial markets were complacent, just like today; they ignored the risks that led to World War I until late in the summer of 1914. Of course, back then the markets were poor at correctly pricing low probability, high impact tail risks. Today, with the interconnected, high technology the markets are still poor at correctly pricing risk, they can just misprice it much faster.