The enemy of my enemy

‘The enemy of my enemy is my friend’ is an ancient proverb that pretty well sums up the global political situation following the Paris terror attack. What short memories some politicians appear to have. Was it not that long ago that European politicians were condemning President Vladimir Putin and imposing sanctions against Russia following the Ukraine crisis? Tensions escalated further when Russia subsequently commenced its bombing campaign in Syria with the West concerned Putin was supporting the Assad regime.

While the conflict in Ukraine remains unresolved, attention is focusing elsewhere. Suddenly world leaders seem to be very keen to have their photo taken with Putin including David Cameron. Putin has been transformed from an outcast to a problem solver at the recent G20 meeting. Press reports suggest that Russian airstrikes have been undertaken against Islamic State targets in Raqqa. Putin has also ordered his forces to ally with France. French President Francois Hollande has called for a ‘grand and single coalition’ while President Barack Obama has said that if Russia shifts its military strategy in Syria to focus on IS then the US would welcome co-operation with Moscow.

Perhaps it is beginning to dawn on world leaders that there is a common enemy –Islamic State.

Which got us thinking. At a headline level, defence cuts have been order of the day in the last few years with pressure on US and European fiscal budgets. Today, the Government has announced an extra £12bn is to be spent on defence over the next ten years. Besides counter terrorism investment, this will also include £2bn on filling the void in Britain’s anti-submarine capability which coincides with reports of a Russian submarine being spotted off the Scottish coast. Elsewhere in the world, China and the USA continue to clash over the South China Sea, with each blaming the other for ‘militarising’ the region.

What have we been watching?

Following an initial setback in markets after the Paris terror attack equities quickly recovered. While airline, hotel, holiday and restaurant groups were initially marked down, defence and cybersecurity companies moved higher, the US market rose strongly which, in turn flowed through into other global equity markets. Markets remained watchful however, with a follow up raid by French police, Brussels on terror alert shutdown and a further terror attack in Mali which had previously received French military support against Islamist groups.

Given the size of the French economy and its importance within the Eurozone, markets seem to be taking the view that the Paris atrocities may increase the prospect of additional stimulus from the ECB when it meets next in December. Indeed in a speech given in Frankfurt, ECB Mario Draghi gave his strongest indication yet that he backs extending QE and adjusting the deposit facility rate to increase the velocity of circulation of bank reserves. The Chief Executive of German engineering business Siemens warned that political instability is making companies more reluctant to invest.

Markets also digested the FOMC minutes which guided to a December US interest rate rise in the absence of ‘shocks’. The reaction was positive as markets are expecting a shallow rate rise cycle and were encouraged by the Fed’s optimism on the US economy.

As our introduction above highlights, the war on terror is changing. Besides more investment in MI5, MI6, GCHQ and more drones, the UK government is to double the cybercrime budget to £1.9bn by 2020 to counter possible cyber-attacks by Islamic State militants on the nation’s electricity supply or air traffic control. Just how difficult it has become for security forces to monitor Islamic State is reflected in unconfirmed press reports suggesting the attackers may have used the Sony PlayStation 4 game console encrypted network to co-ordinate and plan the atrocity.

In the UK, October saw deflation with CPI falling 0.1%, making the eight month in a row where inflation has sat between -0.1% and +0.1%. The lower oil price and strength of Sterling which has made imports cheaper have continued to dampen inflation in the near term. There would appear to be no pressure for the BoE to begin ‘gradual and limited’ interest rate rises until well into 2016 on this basis. A benign interest rate outlook and improving employment market continue to support the housing market with the ONS estimating house prices increased by 6.1% in the year to September.

In Europe, new car sales increased by 2.9% in October although this was below the 9% growth seen in the previous four months and reflected the initial impact on VW from the emissions scandal as its VW brand sales dropped by 0.2%. Germany sold two-year government debt at a record low yield of minus 0.38% suggesting fixed interest investors are expecting further stimulus from the ECB in December. The gap between German two-year debt yield and those of the US has now widened to its greatest level since 2006 reflecting the US interest rate cycle turning against European stimulus. The Euro also slipped to a seven month low against the US Dollar.

By contrast to the UK, in the USA, CPI inflation ticked up to +0.2% in October, reversing the decline of September. Core inflation remained at 1.9% as gasoline, food and air ticket prices increased. This data would appear to add to the likelihood of a December interest rate hike by the US Fed. Indeed the FOMC minutes guided to such an outcome for the meeting on December 16th saying ‘the time for beginning the policy normalisation process had already been met’ and that ‘most’ participants reckoned that conditions to warrant a rate rise ‘could well be met by the time of the next meeting’.

Turning to commodities, concern about the strength of demand in China, the world’s largest consumer of commodities, pushed steel prices to a record low and triggered selling of other raw materials. Copper dropped to a new six year low. Despite news that the US has been bombing Islamic State controlled oil facilities as a way of reducing its oil revenues and arms funding the oil price remained in the doldrums. Concerns that onshore oil storage capacity is nearing saturation seemed to be the main reason.

A sign of the challenges facing some emerging markets against a background of weak commodity prices. Brazilian inflation has risen to its highest level in twelve years at 10.3% while the economy has contracted by over 3%. While Brazil’s debt is still well below that of Greece, it is nonetheless over 66% of GDP but the cost of servicing this debt is about 20%. Looking at emerging markets (EM) as a whole, EM equities are estimated to have delivered a total return of minus 2.1% since the start of 2010, compared with a 69% return for developed markets. The MSCI Emerging Markets Index currently trades at under 13x ten year average earnings which is lower than during the 1997-1998 Asian financial crisis.

Finally, talking of a common global enemy. Scientists have warned that the world is on the cusp of a ‘post –antibiotic era’ after finding bacteria resistant to drugs in patients and livestock in China. It would appear that Islamic State is not the only threat where world leaders need to co-ordinate action and devote greater resources.

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The enemy of my enemy

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