Market hit by fears over Crimea, China

THIS week, the stock market's slide from record levels may continue unless there is a last-minute diplomatic breakthrough in Ukraine, improvement in Chinese data or a change of heart from the Federal Reserve.

Talks between the top US and Russian foreign-policy officials to avoid a schism in Ukraine collapsed on Friday.

A plebiscite in the Crimean region yesterday could result in secession, despite warnings from authorities in the capital Kiev about the referendum's illegitimacy. Clashes between pro- and anti-Russian forces have spread to other cities. Should the Ukrainian army move to keep Crimea under its control, Russian troops massed on the borders of the smaller nation may invade.

While the diplomatic stand-off is priced into stock and commodity markets, "if it looks as if there is an escalation in actual troop movements ... if it looks as if fighting could break out, that's something that could move the market", explained Quincy Krosby, investment strategist at Prudential Financial.

The market's focus on the potential conflict was clear last Thursday when reports of Russian armies amassing on Ukrainian borders for military exercises sparked a major sell-off, said Mr Krosby. As is typical in time of war, the price of safe-haven investments such as Treasuries, Japanese securities and gold futures all rose sharply on Thursday. Gold futures are now trading at six-month highs, and could continue to gain.

On Friday, rumours swirled that a large downdraft in overseas holdings of Treasuries was the financial expression of Russia's turn away from the West. But the selling could have come from another major Treasury holder with a crisis on its hands: China.

Defaults on unauthorised loans in China have destabilised the credit system and the economy in the world's second-largest economy. Hints that China's slowdown could go global showed up in the copper market as the industrial metal hit a four-year low.

Still, the Federal Reserve stands ready to support the US economy from the effects of conflict in Ukraine or instability in China. This week, Janet Yellen will chair her first meeting at the Fed. She will likely pay lip service to both the war and emerging-markets sell-offs without changing policy. Economists say it's too early to tell if trouble in US home sales, consumer spending and even jobs data is a knock-on effect from overseas or merely the fruit of one of the most bitter winters in living memory. This week, weather will again be a disruptive factor in reports on industrial production and housing starts.

Rather than acting peremptorily, Ms Yellen will likely profess vigilance and wait for the winter to lift.

Traders are waiting for a more subtle change from the central bank this week. Ms Yellen and other voting officials have hinted that they are ready to throw out Ben Bernanke's "employment threshold".

In December 2012, Mr Bernanke set a target of 6.5 per cent unemployment as a level that would trigger a hike in interest rates.

Mr Bernanke was trying to buy himself some time because he anticipated inflation would rise to levels where the Fed traditionally raised rates.

On that point, he was wrong. Inflation has remained below the Fed's comfort level of 2 per cent. With the unemployment rate at 6.7 per cent, Mr Bernanke's trigger is about to be activated. Yet all agree that a rate hike is neither necessary nor prudent. For reasons that were difficult to foresee - a historic rise in the number of people dropping out of the labour force, for example - Mr Bernanke's favoured statistic is no longer the best measure of the economy's strength.

Analysts say Ms Yellen will likely reinstall inflation as the principal trigger for policy changes. With inflation muted, the Fed may not be compelled to increase rates until 2015.

The wild card of central bank policy is one reason the stock market is not falling further on Chinese and Ukrainian problems.

"On the one hand, there is the continuing zero bound interest rates and a willingness by the central bank to increase stimulus should the economy weaken," said Lorenzo Di Mattia, manager of hedge fund Sibilla Global Fund, in a note to clients. "On the other hand, there is the real potential for emerging markets to destabilise the global economy, led by a slowdown in China."

After five years of leadership from the riskiest stocks, such as technology, industrial and consumer stocks, the market is now taking on a more conservative tone. Most of the shares that gained value last week were companies with limited international exposure and generous dividends, such as power producers, some large banks and telecommunications concerns. The stock market appears to be in crisis mode.

After an initial "unwinding of risk", traders may revisit the US stock market even if there is a war in Ukraine, said Joe Kinahan, chief derivatives strategist at TDAmeritrade.