Investors have cause to fear an escalation of the conflict in the middle east, but should not overestimate geopolitical risk. It can lead to unnecessary and costly attempts to ‘time the market.’
Meanwhile, who would want a job on the Fed’s Monetary Policy Committee? The U.S. economy is defiant, refusing to be subdued despite the strong dollar, rising Fed policy rates and -particularly since July- a sharp rise in long-dated bond yields. An analogy might be made to the Black Knight, from the film ‘Monty Python and the Holy Grail’. The Black Knight refuses to stop fighting, even as his limbs are cut off one-by-one, defying all logic.
It is this illogic that investors have to negotiate, together with some mixed messaging from the Fed.
Investors should remain in multi asset portfolios that give them exposure to different asset classes, such as equities, bonds and uncorrelated alternatives. Financial history shows that such a mix will deliver the best long-term risk adjusted returns.
Geopolitical risk and timing the market
Capital markets have not responded to recent events in the Middle East as one might have expected. Traditionally defensive assets, such as gold, oil and Treasuries rallied a little, but not much.
Geopolitics can trigger world-changing events, and in extremis, it can crush financial markets (think of German government bonds during the twentieth century). But mostly, macroeconomic fundamentals tend to outweigh geopolitical events.
When there is a direct link, it tends to be when access to resources and/or market is suddenly denied. But even here, markets adept and work round such problems (e.g., look at Germany’s quick weening off from its dependence on Russian gas).
The risk for investors is not the geopolitical events per se, but in overreacting to them. This can lead to being out of the market during a recovery in sentiment. As the phrase goes, what matters in investing is ‘time in the market, not timing the market.’
We cannot ignore the risk that the war in Gaza and Israel may turn into a regional conflict, with still worse to come in terms of human misery and regional instability. We may see energy supplies from the Middle East disrupted, and spikes in prices. But it is hard to see how even this might affect longer-term global economic growth, given the spur that high energy prices give to the alternative energy sector and to higher-cost gas and oil producers elsewhere.
The risk of it happening is surely reduced by the complex antagonisms that exist throughout the region. For example, Sunni powers in the region, such as Saudi Arabia and other Gulf states, will not wish to see Shia-led Iran gain influence in the region, at their expense. ‘Peace talks’ proposed by Gulf states are as much about preventing Iran from claiming to speak for Islam in the region, as they are about preventing bloodshed in Palestine.
The Black Knight U.S. economy versus the Fed
The U.S. economy continues to defy all that the Fed has to throw at it. Interest rates have gone from near-zero to 5.25%-5.5% over 18 months, the central bank is engaged in quantitative tightening, and long-dated Treasury yields have reached levels last seen before the global financial crisis.
And yet the Bureau of Economic Analysis (BEA) is expected to announce, on Thursday, a preliminary estimate of third quarter GDP growth of 4.1% at an annualised rate, up from 2.1% in the previous quarter. Like Monty Python’s Black Knight, the post-Covid American economic cycle refuses to concede defeat.
The labour market remains strong, with new unemployment claims for week to October 14 at lowest level since January (remember, this comes after the astonishing 336,000 new jobs created in September). And last week saw retail sales up 7% month-on-month in September, well ahead of the 3% estimate.*
Annual pay growth is weakening, falling from 6% last March, to 4.3% this July, but this is still above inflation, and so is stimulative at a time when the Fed is looking to reduce demand in the economy.
Inflation itself is uncomfortably sticky: CPI fell to 3% in June, but rose in July and August, and in September was unchanged at 3.7%.** Importantly, rents appear to have stabilised (they have been a driving force this year in the inflation data). But real wage growth may lead to a fresh increase in rents.
But so long as growth remains so strong, the labour market will not ease up, and the risk of a wages/prices spiral will remain.
What is to be done? The cycle needs to end, decisively, in order to create an ‘output gap’ (i.e., enough unemployment to allow for non-inflationary growth). A soft landing may still be achieved. This is often defined as 2% inflation, anchored inflation expectations, and no economic contraction. But achieving 2% inflation without a significant rise in unemployment, along with recession, seems unlikely.
Indeed, to overcome the Black Knight means consistent messaging from the Fed on the ‘higher for longer’ outlook for interest rates, and the avoidance of apparently dovish messaging.
For example, Fed policy members in recent weeks have stated that increases in longer-dated Treasury yields have helped do the Fed’s work for it. This is probably true and they must have a reason for stating it.
But to the uninitiated, advertising the fact is surely counter-productive. It encourages investors to believe that a further rate hike is not coming. This puts downward pressure on yields, and -by the Fed’s own logic- the bond market is no longer being so helpful to its cause.
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