The war in the Middle East has had surprisingly little impact on global asset prices. This may change over the coming weeks, but for now the largest single risk to investors portfolios is perhaps not war, but complacency that a soft landing will be achieved for the U.S. economy.
If the Fed can achieve a soft landing, defined roughly as inflation squashed without a period of economic contraction, a new economic cycle can then begin. But the risk of a recession remains significant – not least because how would the Fed recognise a soft landing when it occurs?
It feels wrong to discuss the tragedy of the Israel/ Hamas war in terms of investment risks. However, not to do so would be to pretend that the war is taking place in a world unconnected to that in which we invest. This is, of course, nonsense.
The first point to make is that global asset prices have not, so far, moved as much as might have been anticipated given the scale of the violence. This may reflect mutual antagonisms amongst would-be combatants.
The asset class most vulnerable is, of course, energy. Yet so far, the rally in the oil price has been minor: $88 a barrel for WTI (as of Monday morning October 6) is up just 6% since before the attack and below September’s 14-month peak of $94. Gold was also up 6% over the week**, ending at $1,933 an ounce. But half of that increase came in the wake of Thursday’s U.S. inflation report!
Treasury yields fell (and their prices rose) in the aftermath of the attack, as one might have expected. They are investors favourite asset class during periods of geopolitical turmoil. But Treasury yields quickly rose again in the wake of last Thursday’s mildly disappointing September CPI inflation numbers. The Treasuries’ auction of 30-year bonds last week met with less demand than had been expected, given the highest yields since 2011.
What of risk assets? Wall Street rallied early last week, reflecting the strong September non-farm payrolls report of the previous Friday and as if there was no war.*** Risk appetite then waned and the S&P500 was flat overall.
The reason may be the limited response from the countries that many see as potential agitators in the region. This, in turn, may reflect the complexity of their mutual antagonisms.
Sure, Saudi Arabia, Qatar and Iran all issued statements immediately after the Hamas attack that -to varying degrees- blamed Israel, for bringing the attack upon itself. President Putin blamed U.S. policy and has taken the opportunity to increase Russia’s hammering of Ukraine.
But no third party has so far become engaged in the conflict (aside from Iran-backed Hezbollah, which has fired some rockets into northern Israel from Syria).
Perhaps third parties are deterred by a growing U.S. naval presence in the Mediterranean Sea, close to Israel.
But also, the potential antagonists do not share the same agenda and they have wildly differing goals. Anti-American feeling might unite Russia and Iran, but the former has nothing against the country of Israel per se, in contrast to Iran’s desire to extinguish the Jewish state.
Saudi Arabia, and other Sunni Gulf states, affection towards Shia Iran is paper-thin. The two sides having fought each other, through proxy militias in Iraq and Syria. for much of the last two decades.
What could frighten investors?
So long as regional players, including Russia, stay out of the war it seems unlikely that financial markets will react any further, to any significant degree. However, there is a risk that a third-party does enter the conflict and there lies complete unpredictability.
For instance, should Iran enter the war directly, in a bid to consolidate its power in the region, what position would Saudi Arabia and other Sunni states take? They have no interest in seeing Iran gain power and may see advantages in allying themselves more with Israel and the U.S. against Iran.
Energy supplies from the Middle East would be threatened, putting upward pressure on global inflation. Gold, Treasuries and other defensive assets and currencies can be expected to rally.
But we are not there yet. And for now, the biggest risk to investors is the apparently strong assumption that the U.S. is heading for a soft landing.
The soft-landing argument hits labour market data
Thursday’s CPI inflation showed core inflation rose a little higher than expected in September, up 3.7% over the previous year.**** But September’s rise is likely to prove a blip. Much of core inflation is made up of shelter and privately run data providers, such as Zillow, indicate near-zero increase in newly agreed rents month-on-month.
Therefore, the Fed may pause interest rate hikes on the assumption that, despite economic growth currently of around 3% (hardly sluggish), inflation is set to fall. Reassuringly, long-term inflation expectations remain anchored in the 2.5%-2% region.
But…the risk of a wage-prices spiral is considerable, given still-strong wage growth and tight conditions in most labour markets. Unemployment is just 3.8%. September’s non-farm payrolls showed new jobs growth of 336,000 against expectations of 170,000. Wage growth of around 6% is stimulating demand at a time when the Fed wants to cut demand.
Given the risk that wage growth fuels a new wave of core inflation, the Fed may consider a further rate hike worth the risk.
Unfortunately, with every interest rate hike, the risk of something breaking in the financial system, and/or the lagging effect of rate hikes on economic activity, increase. The first would trigger a curtailment of supply of credit, the latter a curtailment of demand for credit.
And that could end the economic cycle with a bump. No soft-landing.
A period of economic contraction is surely the more likely scenario that creates the unemployment required to end wage growth. This, in turn, will reduce demand in the economy sufficiently to allow headline CPI to fall to the Fed’s 2% target.***** A fall in corporate earnings appears inevitable, testing investors’ tolerance for current high valuations on Wall Street.
Investors should look to hold a variety of assets that will provide opportunities and protection against a number of different scenarios. Financial history shows that a balanced portfolio, containing equities, bonds and alternative assets will deliver optimal risk-adjusted returns over the long term.
* https://oilprice.com/oil-price-charts/ (as of Monday morning, U.S. Eastern Time)
***** For example, The Federal Reserve Bank of Cleveland’s average 10-year expected inflation report is currently at 2.4%. High by recent history, but low by comparison with previous decades. See: Inflation Expectations (clevelandfed.org)
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