MorningWord 8/7/14: Vol Around the World

by Dan August 7, 2014 9:34 am • Commentary

Since making a new all time high on July 24th, the S&P500 is down about 3.5% despite what has been some fairly good economic data here in the U.S., coupled with largely better-than-expected Q2 earnings.  Maybe U.S. equities are just taking a breather, and this dip, like everyone before it for the past 5 years is a buy. But I think it is important to note what appears to be some serious deterioration in some of the factors that helped get us here, plus some fairly new headwinds.

Obviously, geopolitical risks abound and some of the recent data out of Europe points to uncertainty putting a strain on even the strongest Euro economies like Germany.  Just this morning, Russia countered western economic sanctions with import restrictions of food from the U.S. and Europe.  While this may sound a bit slight, this could be just the start as some reports suggest they could close commercial air routes over Siberia.  This is just the sort of stuff that could take the air out the long fought recovery of many industries and potentially entire regions, as it is clear that the recovery here and in Europe is on fragile footing.  Several European companies (like Adidas and Siemens) have already commented on the Russian sanctions affecting business, and Mastercard pointed out that Europeans have increased intra-Europe travel at the expense of travel outside of Europe.  Will we start to hear U.S. multi-nationals talking down Q3 and the balance of the year for business disruption in Europe?

Add to that the very sad situation across the Middle East. It seems like the entire region is burning with huge human costs.  I won’t even go into the politics, but the primary concern for Western markets is the flow of oil, which seems fine, and prices seem contained.  This could obviously change very quickly, and the biggest risk in my mind is some large unforeseen event that places the unrest in the form of terrorist acts immediately in the face of our interests.  Will we start to hear U.S. multi-nationals talking down Q3 and the balance of the year for the potential of increased input costs if Oil prices flare again?

Then there has been China. While the mess in Eastern Europe and the Middle East has pushed China’s recovery to the 2nd page of the business section, there have been some situations as it relates to U.S. stocks that are notable in my opinion.  First YUM, who derives more than 50% of their sales and is set to get much of their future growth from China, just hit a roadblock with what seems like their never-ending saga with meat suppliers in the country.  The stock went from a 52 week high in the middle of last month to 6 month lows.  Then there is WYNN, who also gets a disproportionate amount of sales and future growth from Macau, and the stock is now flirting with 4 month lows, and nearing a 20% decline from the all time highs made in February.  Not to mention all of the rumblings from the Chinese govt with U.S. tech firms that have recently been a bit of a headwind for growth in the country (read here). Will we start to hear U.S. multi-nationals talking down Q3 and the balance of the year if China prints growth slower than the targeted 7.5%?

The point here is that U.S. multinationals are very much connected to the prospects of other regions around the world.

U.S. equity vol, while elevated from the multi-year lows in just the last month, remains well below the long term average, and does not appear to be pricing much risk on this front.  The persistent bid to U.S. Treasuries is a reflection that investors are looking for potential safe havens, but they have so far only slightly reduced stock positions around the globe.

Even with the recent move in the VIX, it is still at the low end of the 5 year range:

VIX spot weekly chart, Courtesy of Bloomberg
VIX spot weekly chart, Courtesy of Bloomberg

Are those geopolitical risks being adequately priced?  Have investors taken into account the potential downside to corporate earnings if the risks intensify?  Probably not. But of course, that’s mainly because over the past few years, any possible risk turned out to be a false alarm.  That’s all fine and well, but stock investors might want to set aside a rainy day fund… just in case it does actually rain one day.