Market Commentary: Geopolitical escalation increases market volatility

In what was a roller coaster week last week in global markets, particularly bond markets, spreads compressed ending the week tighter. Geopolitical escalation and de-escalation has resulted in increased market volatility, however, over the last few days, bonds rallied as there was no apparent news of escalation in the last few trading sessions.

Economic data releases in the euro-zone continued to fall short of expectations throughout most of last week, and there seem to be no signs of abating, as the region’s economic recovery came to a complete halt in the second quarter. There could be timid signs suggesting that growth could resume in the third quarter, but this is expected to be extremely modest, at best, as downside risks related to the effects of the Ukraine crisis as well as the forthcoming bank stress tests continue to be at the fore. Spare capacity seems to be eroding slowly as euro-zone inflation looks set to remain far below the ECB’s target of 2.0%. This coupled with weak growth and low inflation could result in possibly additional austerity measures from this point forth, evidencing the fact that additional monetary policy support is desperately needed. This week sees the release of some of the first euro-zone survey data for August. Falls in EC consumer confidence and in the PMI business surveys are likely to add to the recent run of bad news.

Elsewhere, US Federal Reserve officials will be eagerly looking forward to their annual policy rendezvous at Jackson Hole later this week. Not much is expected in terms of monetary policy outlook as the focus on labour market dynamics could well indicate some possible implications for monetary policy if it appears that the FOMC members are deviating from their previous stance that labour capacity is still in abundance. In what is expected to be quiet week, CPI inflation and data on the housing market will be closely monitored. The decline in the University of Michigan's consumer confidence index to an eight-month low of 79.2 in August, from 81.8, primarily reflects the recent equity market decline. FOMC minutes to be released on Wednesday could reflect a more hawkish tone as the Fed acknowledges that unemployment is no longer on the upside and that the risk of low inflation has somewhat diminished.

Meanwhile, the trend in oil price has reverted downwards, despite temporary spikes, as there has recently been a marked decline in the geopolitical risk premium, against a backdrop of ample global supply, rather than a sudden slump in demand. In essence, the recent weakness in crude oil prices, despite the apparent escalation in political risks threatening key producers in the Middle East and Russia, has caught most analysts by surprise.

Geopolitical risk and the euro-zone recovery and/or deflationary scenario are expected to continue to set the tone for the remainder of the month, as people return from holidays in September. Nevertheless, fighting is ongoing in Eastern Ukraine and the Ukrainian parliament is planning a law on restricting Russian supplies to Europe flowing through Ukraine. Consequently, a geopolitical trigger for further widening could not be ruled out if we add the Iraq and Gaza conflict to the equation.

On a positive note, US HY funds saw positive inflows throughout last week, helped in part by the easing of tensions in geopolitical risks. This saw ‘bottom fishers’ finding their way pumping money back into the market at cheaper levels. US HY Funds and ETFs have in fact seen the first positive weekly inflow in over a month.

This article was issued by Calamatta Cuschieri, visit www.cc.com.mt for more information.
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