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It is never easy to write market commentary in the face of humanitarian tragedy. It’s bad enough when it has been the result of what some might describe as “Acts of God”, but even worse when it is human agency that has been the cause. That is very much the case with current events in Israel and Gaza, and our thoughts are very much with those involved in and affected by the situation.
Even so, as investment professionals we are compelled to view what is unfolding through the lens of financial outcomes. Anyone with access to no news, other than headline weekly financial market prices, might be forgiven for thinking that the world was an unusually serene place last week. Bonds, equities and, by extension, balanced portfolios, ground out small gains and currency markets were relatively subdued in comparison to recent experience. That said, there were a few clues as to something more sinister lurking beneath the surface. The VIX volatility index ended the week at 19.32, approaching the 20 level that is often associated with greater stress in the US equity market. Small and mid-cap shares performed relatively poorly again as concerns about the risk of a sharper economic slowdown ahead persisted. And the price of gold, a traditional bolt hole, jumped more than 5%, admittedly after a period of distinct weakness.
The biggest mover of the week was oil, with Brent crude up around 7.5%. All the gains came on Monday and Friday, but very little happened in between. The first move was the immediate reaction to the potential for wider conflict in the Middle East; the second to concerns ahead of the weekend that a ground attack by Israel into Gaza would draw in other actors, not least Iran-backed Hezbollah from Lebanon. It is clear from the diplomatic efforts being made that there is no desire amongst global superpowers (with perhaps one key exception) for the situation to escalate. And although humanitarian concerns should be at the forefront of all negotiations, it is clear that the risk of disruption to oil supplies, and what that might mean for inflation and already fragile global economic growth, is also a factor, especially just over a year away from the next US Presidential election.
Iran is the key focal point here. It is a major exporter of oil, currently supplying around 2% of daily needs to the rest of the world. It also effectively controls the Strait of Hormuz, or at least has the greatest capacity to hinder shipping through there. That could be much more serious, as around 20% of global oil supply makes its way through that stretch of water. If Iran is proved to have been complicit in the initial or subsequent attacks, then it could find itself subject to export sanctions once again. Thereafter, it could retaliate. All of this is obviously in the realm of speculation, but we have to anticipate such scenarios.
To complicate the geopolitical picture, the events in Israel and Gaza threaten to divert both political attention and funds from Ukraine, suggesting that Russian President Putin might be quite happy to see things getting worse.
And so, why have markets appeared so sanguine? Despite the obviously shocking numbers in terms of the initial casualties and the brutal nature and scale of the attacks, violent confrontation in the region has been part of the background narrative for decades, and so did not have the same shock factor as, for example, Russia’s invasion of Ukraine. Neither is Israel a large exporter of essential commodities. And so, we await the result of current diplomacy, although with a still-cautious bias.
Elsewhere in financial markets last week, investors remained under the influence of the bond market, specifically the US bond market. An initial rally as investors sought safe havens ran into a headwind of supply, with a poorly received bond auction on Thursday pushing yields back up. The scale of potential supply of US government bonds has become an increasingly hot topic in recent weeks, with the size of the US fiscal deficit, running at around 8% of GDP this year, a cause for concern. To some degree, the market was shielded against this earlier in the year, on two fronts. First, the debt ceiling impasse meant that no new debt was issued for several months, during which period government spending was largely funded from the Treasury General Account. Once the debt ceiling was agreed, the TGA was rebuilt and current spending was funded from an aggressive issuance of short-dated Treasury Bills. As the summer progressed, there was a shift back to longer-dated funding and this, along with the persistence of growth, impatience with the fall in inflation and tough talk from the Federal Reserve, has been a key driver of rising yields.
Fiscal deficits have two sides to them. There has been a lot of attention paid to the levels of spending by the Democrats, which have been driven by a combination of expansive policy decisions, the inflation-linked uprating of social security payments and, more recently, the rising interest bill. But less has been said about the income side of the equation. Tax receipts are already under pressure from financial markets, with capital gains tax receipts, especially, dwindling as markets deliver little by way of capital gain. Should a recession develop, that would eat further into income, especially from corporate taxes.
The recent rise in bond yields is playing out through the real yield, or the yield above expected inflation. If one takes the US 10-year real yield, effectively the global benchmark, this has risen from around 1.5% at the beginning of the year to a current 2.3%, having briefly flirted with 2.5% in the last couple of weeks. This introduces the slippery concept of the term premium, or the extra yield that investors might demand over and above expected base interest rates, to compensate for the risk of higher and more volatile inflation in future or for the threat of a greater supply of bonds. As with a lot of things in financial markets, the current term premium can be inferred from a combination of various inputs, but, in reality, can only be properly calculated on an ex-post basis. But the consensus opinion is that it’s going up.
This has an important bearing on equity markets owing to the discount rate effect on net present values of future cash flows. The FT’s Unhedged column specifically mentioned it on Monday in relation to the derating of Consumer Staples stocks, which are often considered to be “bond proxies” *. One could also observe it in the fact that Utilities – another sector whose performance tends to correlate strongly to bonds owing to long-term stable revenues – is the worst-performing sector in the US this year, having fallen 16%.
If only it were that simple. What about the duration effect? Shouldn’t the longest-duration assets have been the worst performers? Not necessarily in the US, where big cap Tech has led the indices higher (although more speculative non-profitable companies have continued to struggle). It could be that expected growth, buoyed by optimism about AI, has outrun the higher discount rate. Or it could be the perceived relative safe haven status of unleveraged, high margin global leaders. Maybe it’s the relentless flows into indexed funds. Probably a combination of all of them. But we continue to believe that this relentless upward grind of bond yields and de-rating of other high-quality equities will set up a very attractive longer term investment opportunity.
*There are other factors at work here, not least worries about the long-term effects on demand for their products which might be reduced by the widespread adoption of a new class of drugs (GLP-1s) that suppress the appetite and help lead to weight loss with positive impacts on long-term health. This is a subject worth returning to at a later date.
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