Question #1 for 2018: What Will Move the Markets?
We are running a special 3-part series this week on investment themes for 2018, so we’ve asked each of our analysts to respond to the following question:
“What major geopolitical event/circumstance do you expect to affect your coverage area the most in 2018?”
Oil prices could rise more than expected in 2018 due to Saudi Arabia’s sale of a 5% interest in its state-owned oil business and heightened economic sanctions against Russia in response to fallout from its meddling in last year’s U.S. presidential election.
The combined effect of those two events, voluntary production limits by OPEC plus an involuntary embargo on Russian oil by NATO countries, could trigger a spike in oil prices. That would exacerbate rising interest rates, which in turn might cause the bond bubble to burst.
Let’s hope that doesn’t happen since that would disrupt the entire financial market ecosystem, but if it does occur then the repercussions will be felt throughout the global stock and bond markets.
Global crude oil inventories are finally moving down into a normal range. This is important, because it reintroduces oil price volatility in response to geopolitical events. Over the past three years, crude inventories have been so high that geopolitical events that would have rocked oil prices five years ago made little difference in the price of oil. But a notable shift has taken place in the past few months, as evidenced by oil prices moving sharply higher over recent unrest in Saudi Arabia.
OPEC recently committed to keeping production cuts through the end of 2018. If the cartel follows through, oil prices should move steadily higher as inventories continue to deplete. The major areas to watch in 2018 will be Venezuela and Saudi Arabia. Venezuela remains one of the world’s leading oil producers, but the economic situation there continues to deteriorate and the country’s oil production is shrinking as a result.
But the real key will be Saudi Arabia, which is in the midst of the most significant restructuring of the political order in decades. There is potential there for unrest, which would make the oil markets extremely nervous. Further, Saudi Aramco still plans to launch an IPO in 2018 and it would like oil prices to be at least as high as $60 per barrel. Expect the Saudis to take aggressive action as needed to keep the price of oil elevated.
China’s continued rise as the world’s biggest trader and biggest economy will be the most important reality in 2018, as it has been since the start of this century.
I expect China to take steps towards establishing a new reserve currency that will include a role for gold. The process will likely start with China launching an Eastern oil benchmark. Initially, the oil futures contracts will be traded in yuan, which will be backed by gold as China eases restrictions now in place on exporting gold.
I expect that scenario rather than a gold-backed yuan. Trading of oil and then other commodities in the East will be conducted in a basket of currencies, such as the SDR, to which gold has been added as a component.
As an options trader who profits from selling the time-value component of option prices, my focus is on those risks that increase stock market price volatility. Consequently, although the North Korea nuclear crisis is an obvious candidate for biggest geopolitical risk, the fact that stock-market volatility has remained at historic lows during the crisis tells me that it is not where the real risk lies.
The risk of crude oil price shocks is the real story of 2018. A breakout of hostilities in the Middle East between Saudi Arabia and Iran would send oil prices skyrocketing since 20% of the world’s oil supply travels through the Strait of Hormuz in the Persian Gulf.
A debt default and economic collapse in Venezuela (home to the largest oil reserves in the world) could happen simultaneously, disrupting oil production even further, which could create an unpleasant combination of inflation and recession (a.k.a. stagflation) that would be sure to cause stock-market volatility to spike.
The most likely source of risk is in Asia, specifically the Korean peninsula where the rogue totalitarian state of North Korea continues to rattle its saber. Further heightening the danger has been the bellicose response of the United States to North Korea’s provocations. The White House’s extremely hawkish foreign policy stance will continue to prove a wild card around the globe in 2018.
The Middle East is another potential flashpoint, with possible disruptions of oil markets. Saudi Arabia’s economic restructuring could sow civil unrest. China is growing more assertive as Trump’s “America First” policy causes the U.S. to retreat from various international agreements, allowing China to rush into the leadership vacuum. This makes China’s neighbors in Asia increasingly nervous.
The upshot: 2018 will likely witness greater demand for aerospace/defense, especially for high-margin jet fighters that are popular export products. U.S.-based aerospace giants have done well in 2017; this prosperity should continue in 2018.
Paradoxically, heightened tensions in Asia could weigh on the technology companies that are based in fast-rising emerging markets such as Taiwan and South Korea. Caught in the crosshairs also will be Japan. The outbreak of outright war overseas would tank global markets.
I don’t think it’s possible to have an event in 2018 that could be as surprising as the Trump election. However, Democrats will continue to gnaw away at the Republican lead in the Senate. The Democrats need to gain just two more seats to upend Republican control there.
Mid-term elections won’t happen until the fall of 2018 but before then, many left-leaning Republicans may start to cross party lines. Alabama Republican Roy Moore’s rough loss in Alabama this past December shows the limits of President Trump’s influence. This might lessen the loyalty of some GOP members.
All of this jockeying means the government will basically be roadblocked from passing major legislation. I see bearish opportunities in sectors flying high off optimism that the government would fund their growth and bullish opportunities in those sunk off fears of government restrictions.
When it comes to dividend stocks, the Federal Reserve is the 800-pound gorilla. That’s because as rates rise, the yields on fixed-income securities, such as risk-free U.S. Treasuries, become more competitive with the yields of our favorite dividend payers.
Of course, I thought the Fed’s actions this year would weigh a lot more on rate-sensitive sectors. Instead, utilities have had another surprisingly strong year, even outperforming the broad market until recently. The question is whether the Fed will continue tightening monetary policy gradually, or whether a stronger economy will force it to pick up the pace.
Right now, for instance, there’s a big disconnect between traders and central bankers. Action in the federal funds futures market implies two quarter-point rate hikes next year, which would take the upper bound of the benchmark rate to 2.0%. Regardless of where rates end up, research has shown that dividend stocks can still perform well during a rising-rate environment. The secret sauce is dividend reinvestment; its compounding effect goes a long way toward creating truly enduring wealth.
The most important variable is China. I expect the state of the Chinese economy to play the most significant role in determining the direction of global markets. China is trying to juggle deleveraging while keeping its growth rate high. Gross domestic product growth in recent quarters has been strong, suggesting success so far.
America’s withdrawal from the Transpacific Partnership left a leadership vacuum, and there’s no doubt China is more than happy to fill that role to strengthened its relationships with its neighbors, increasing its economic influence.
At a recent 80th commemoration of the Nanjing Massacre, President Xi Jinping attended but did not speak, a rarity for the Chinese supreme leader. The silence is a clear sign of an improved relationship with Japan, a former staunch U.S. ally.