Possible military conflict in Syria unnerves markets

There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can. – Mark Twain

As if investors did not have enough to worry about already, talk of a possible military strike against Syria unnerved the markets last week and promises to add to the uncertainty as we enter the month of September. While Secretary of State John Kerry laid out the case for air strikes against Syria and President Barack Obama reiterated the need to act, the decision will ultimately not come until Congress reconvenes on September 9^th and casts a vote either for or against military action. The markets are likely to benefit in the short run from a postponement in the decision to attack Syria. However, the continued uncertainty over military intervention will likely keep the market constrained. It’s also important to review past history with regard to the relationship between military conflicts and the performance of the stock market. Just two years ago, the S&P 500 fell 4.8% leading up to an air assault against Libya but recovered 5.0% two months later. Similarly, prior to the invasion of U.S. troops in Korea in 1950, the S&P 500 dropped almost 6% but proceeded to climb back 4.2% in the ensuing two months after the war had begun. The same scenario has played out in other military conflicts as well. The uncertainty of war seems to be far worse than actual war itself, at least as far as the stock market is concerned. The potential bad news becomes priced into the market and when the crisis passes, the market breathes a sigh of relief and tends to move higher.

Last Week

The economic news definitely provided investors with a mixed bag last week. Orders for big-ticket items fell 7.3% in July, much greater than expected, as there were far fewer contracts for jet aircraft and military orders. This was the first such decline in durable goods in four months. Later in the week, though, second quarter GDP growth was revised to 2.5% from an initial reading of 1.7% on better than expected data on the U.S. trade deficit. News on the housing front was also mixed as the Case Shiller composite index on single-family home prices rose 0.9% in June but pending home sales saw a decline of 1.3% in July. This was the second consecutive month of declines and probably the result of higher mortgage rates.

While the number of people who applied for state unemployment benefits last week declined to the lowest level since late 2007, consumer spending and personal income posted meager gains, indicating that consumers are still struggling in this sluggish economy. Although steady job growth has been occurring every month, the overall economy is still down about 2 million jobs from the start of the Great Recession. This also probably explains the slight drop in consumer sentiment in August as people are less optimistic about the current and future state of the economy.

For the week, the Dow Jones Industrial Average dropped 201 points to finish the week at 14,810, a decline of 1.3%. The S&P 500 lost 31 points or 1.8% to end the week at 1,633 and the Nasdaq Composite index fell 1.9% or 68 points to close the week at 3,590.

This Week

All eyes will be focused squarely on the employment data that is to be released on Friday. The consensus estimate among economists is for total non-farm payrolls to increase by about 180,000 and for the unemployment rate to remain unchanged at 7.4%. It also will be interesting to see the breakdown of jobs between part-time and full-time as the latter have higher wages as well as health care ramifications. This will also be the last jobs report before Federal Reserve officials meet later in the month to discuss Fed policy and the fate of its stimulus program. While it is widely believed that the Fed will begin to taper at that time, a strong case could also be made for postponement of any reduction as well. The potential conflict in Syria and its uncertain consequences, the adverse effect of higher interest rates on the housing market and the probable debt ceiling debates between Congress and the White House all would seem to make good arguments for a delay.

Leading up to the jobs report is the release of construction spending for July, which should be better than the previous report, and August manufacturing data, which should show that manufacturing continues to improve. G-20 leaders are also scheduled to meet at a summit in St. Petersburg, Russia but in a sign of continued strain in their relationship, President Obama has canceled a meeting with Russian President Putin. 

Portfolio Strategy

Although the stock market suffered its worst August in two years and faces an uncertain September, which historically has been a weak month, there are enough positive reasons to remain optimistic about equities. Global growth among developed countries is accelerating as evidenced by the purchasing managers index reports both here and abroad in Europe and China. Despite higher mortgage rates, the housing market in the U.S. is still relatively strong, the energy sector is booming and the job market is showing steady improvement. Liquidity and monetary conditions by central banks around the world are still supportive and any hike in rates by the Fed probably won’t occur until 2015 at the earliest. Equities also continue to be the least expensive of the major asset classes and valuations are below all prior bull market peaks as measured by the price earnings ratio. Furthermore, money is flowing from bonds to stocks and this trend should continue, as well as the potential for corporations in the U.S. and Europe to buy back their own stock with the $2 trillion sitting on their balance sheets.

Bond investors should also take heart in the fact that although growth is expected to improve, it will not likely exceed 3% anytime soon. In fact, third quarter GDP is likely to remain soft before picking up in the fourth quarter. Inflation, which can erode the value of fixed income investments over time, should remain tame as it has been running well below the Fed’s target of 2.5%. While the Fed may begin tapering its monthly bond-buying program of Treasuries and mortgages as early as this month, it’s not expected to raise the Fed Funds rate until 2015. All of these reasons support the value of taxable and tax-exempt bonds in portfolios, especially since the recent spike in rates has made yields more attractive.