Wealth Insights | Weekly Market Analysis | Economy | Asset Allocation
Weekly Market Analysis - Geopolitical Shocks, Inflation and the Patient Portfolio
Posted on3 Things to Know
State to State Conflict in the Middle East
This was the first direct state-to-state attack between Israel and Iran after the events of October 7, 2023. This changes the parameters of the regional conflict. In such events, the initial reaction is very often an “overshoot.” The price of oil - a key metric for global impact – typically moves as a multiple of any feared production loss, followed by a drop. While markets will recalibrate future risks over the coming days, rarely do such events change the direction of the world economy.
US Inflation Print May Stoke Rate Fears
The US Consumer Price Index (CPI) rose for a third consecutive month in March exceeding expectations and stoking inflation fears. The US Federal Reserve says it needs confidence that its preferred measure of inflation is lastingly on its way back to a 2% trend pace. This means a rate cut before July is unlikely. During this time, markets are more vulnerable to rate fears.
Broadening EPS Gains
We believe 2024 will offer a broadening set of positive returns relative to 2023 as more sectors post EPS gains. Our asset allocation reflects a broadening strategy to take advantage of wider gains. We overweight the S&P 500 equal weight index to reduce concentration risk and seek to take advantage of “catch up” opportunities.
Summary
MIDDLE EAST
Iran’s direct attacks on Israel via missiles and drones is a material escalation of an intensifying regional conflict. For markets, the event was well-anticipated and the initial reports of casualties from the bombardment were few. This may limit the response in financial markets, with crude oil still likely to have a large initial move. As Wealth Outlook showed, less than 10% of significant geopolitical shocks and conflicts have changed the direction of the world economy.
US INFLATION
With last week’s data, the US CPI posted three monthly upside surprises relative to consensus expectations. We believe 2024 will offer a broadening set of positive returns relative to 2023 as more sectors post EPS gains. But we expect the Fed to maintain a restrictive stance until the deceleration of inflation resumes. During this time, markets are more vulnerable to rate fears and the latest geopolitical escalation.
Portfolio considerations
We believe 2024 will likely offer solid growth and returns on both equities and bonds. While not as spectacular as 2023, we believe growth will broaden well beyond tech and pick up internationally. In our view, it’s possible that 10 of 11 S&P sectors will see earnings per share (EPS) gains this year. And while this is going on, the “inflation scare” headlines create opportunities in High Grade intermediate bonds which we believe offer good value to investors in this current environment. Equity risk hedges – for suitable investors – also appear attractive and historically cheap.
Source: Bloomberg as of April 5, 2024. Sectors proxied using S&P 500 Sectors (Level 2). Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees, or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events.
State to State Conflict in the Middle East
For global markets, the largest impact of the conflict was always likely to be felt in the price of oil. We would still expect financial markets to immediately price in a higher possibility of enlargement of the conflict through higher risk premiums. Given the rapid timeframe for production and consumption of oil and related products, the oil price tends to move very sharply relative to actual supply impacts. As was the case following Russia’s invasion of Ukraine in 2022 and Hamas’s attack of Israel in late 2023, oil markets feared a larger supply disruption initially. These fears then faded as greater clarity around supply followed. While we cannot know the future course of the Iran/Israel conflict, we believe there is a high probability that this pattern will unfold again.
In our Wealth Outlook for 2024, we note that geopolitical risk to oil supplies suggests a greater need for investment in energy security – redundant energy supplies – even as energy demand is being satisfied by a new mix of energy sources. Russia and Iran depend on petroleum exports for revenue and unlike the 1970s, the US has risen to be the world’s largest petroleum producer. Therefore, a repeat of the energy-rationing inflationary-recession of 1974 is unlikely.
Multiple conflict zones and economic growth have generally co-existed for much of history. As Wealth Outlook showed, less than 10% of significant geopolitical shocks and conflicts have changed the direction of the world economy. Most have had very short-lasting impact on financial markets.
US Inflation Print May Stoke Rate Fears
With last week’s data, the US CPI posted three monthly upside surprises relative to consensus expectations. Last year, the consensus formed around a rapid decline in inflation. In the final quarter of 2023, inflation annualized at just 1.9%. Had this been sustained, the Fed would have had no reason to maintain its “considerably restrictive” policies.
We still expect the headline CPI to rise just 2.5% in the year through December 2024. We have not lost confidence that global demand and supply growth are gradually moving into balance. And we still believe that equity markets will benefit from higher-than- expected US corporate profits likely to be reported over the coming month (see last week’s CIO Bulletin). Nonetheless, financial markets are prone to excesses of optimism and pessimism. Shorter-term US Treasury yields have moved broadly, with rate cut expectations moving from 2 cuts in 2023, to 7 early in 2024, and back to two cuts now.
We continue to believe current market pricing for hedging strategies appears favorable. This means that call premiums are high and that put costs are lower than recent historic average. This allows investors to consider exchanging upside for downside protection. Such a strategy – for suitable investors – should help them stay the course during the “bumps” in what we expect to be an enduring expansion.
Our own preferred measure of core CPI inflation has bounced from a 2.0% to a 2.4% pace over the last five months. Therefore, we expected the Fed to maintain a restrictive stance until the deceleration of inflation resumes. In our own view, this could come sooner than markets now expect, but not likely in the next two months. During this time, markets are more vulnerable to rate fears.
Broadening EPS Gains
We believe 2024 will offer a broadening set of positive returns relative to 2023 as more sectors post EPS gains (see chart). Our asset allocation reflects a broadening strategy to take advantage of wider gains. For example, we overweight the S&P 500 equal weight index to reduce concentration risk and seek to take advantage of “catch up” opportunities including healthcare in particular.
While we expect solid performance for both equities and bonds in 2024, “headline” index performance was never likely to be as strong as 2023, which followed sharp losses in 2022. Returns for the S&P 500 over the past six months would have annualized near 50%. In short, equity markets were appreciating too fast to be sustained.
We believe investing in economic development – generating capital appreciation and income – is still the paramount opportunity for wealth preservation and growth. The precise number of rate cuts in the remaining 8 months of 2024 is trivial by comparison.
