With stocks setting all-time highs almost as frequently as World Cup fans leap from their seats to watch a shot for a goal, investors might get the sense that the market will keep advancing indefinitely. However, recent developments in Iraq, and their direct impact on oil prices, could be the “X” factor that throws a wrench in the now five-year-plus bull market rally.
Iraqi militants, including members of ISIS (Islamic State of Iraq and Syria) have taken control of most of western and northern Iraq, including the city of Tal Afar and its strategic airbase. Iraqi forces have retreated, overwhelmed by the militants, leaving multiple towns and large swaths of the country undefended. Militants have also taken control of the key refinery just 40 miles north of Baghdad, and now threaten to take control of Baghdad without Western assistance.
The ISIS militants would be no match for U.S. forces, but no one wants to see U.S. boots back on the ground in Iraq after we have fought so hard to withdraw. Still, President Barack Obama has authorized as many as 300 troops to return as advisers to the Iraqi military, but has stated that any additional support is contingent upon Prime Minister Nouri al-Maliki being replaced. Over the weekend, Iran’s “supreme leader,” Ayatollah Ali Khamenei, called U.S. policies in Iraq “interference” and made it clear that Shiite Iran does not support U.S. plans to find a new leader for Iraq.
Rising tensions in Iraq, not the least of which is the increasing animosity between the United States and Iran, are pushing oil prices ever higher. From a recent low of around $90 per barrel in January, crude oil closed last week at $107.12. Just since the beginning of May, crude has jumped from $98 per barrel, or by almost 10 percent.
Short-term spikes in oil prices typically have little effect on the economy. Extended periods with elevated oil prices can have serious negative implications for the economy, however. If we see continuing tensions in Iraq, oil prices could easily rise significantly, with some estimates as high as $120 to $130 per barrel. Should prices reach these levels, economic activity will certainly suffer as consumers struggle to afford to fill up their gas tanks. We got a small taste of the devastating impact rising oil prices can have on the U.S. economy when gasoline prices spiked to above $5 per gallon here locally. Vehicles began appearing abandoned on freeways across California, and in many other cities, as those living paycheck to paycheck were running out of gasoline, unable to afford to keep gasoline in their cars.
So far the militants have focused on the northern part of Iraq, which holds significant oil reserves, but does not represent significant oil production. Iraq’s primary oil production and loading facilities are in the southern part of the country, and so far are secure. Should militants push deeper south, increasing the threat to oil production and transportation, oil prices are certain to head substantially higher.
We will receive the final report on first-quarter GDP growth in the United States this week. The previous report showed GDP growth of -1 percent annualized for the first quarter of 2014. Economists are expecting a sizable revision, to -2 percent annualized growth. Most economists believe this report will be largely ignored because economic growth (supposedly) has rebounded significantly in the second quarter.
With about one week remaining in the quarter, the recent spike in oil prices may not have much of a negative impact on second-quarter growth. But, if second quarter growth is weak for other reasons (and there are plenty of reasons to believe second-quarter growth has not been stellar), and oil prices continue to rise well into the third quarter, we could be looking at the first three quarters of 2014 with either weakly positive or even possibly negative GDP growth.
All of this potential economic weakness has been occurring and may continue to occur with the Fed actively removing stimulus at a pace of $10 billion per month, and targeting the end of summer to remove all remaining stimulus from the economy. In addition, the Fed plans to begin raising interest rates sometime next year, and likely within the first half of next year. Although the Fed certainly can slow the pace of removing stimulus, and can delay raising rates, its intentions are clearly to take decisive actions to prevent inflation from getting out of control.
While we cannot be certain that the situation in Iraq with escalate, there is plenty to be concerned about for U.S. equity investors. The price of oil is just one more variable that must be seriously considered, given the current level of the stock market, and investors long in the market should keep a close eye on oil and its impact on stock prices and the U.S. economy as events in Iraq unfold.