The three things investors should know about this week
The US and Iran are resuming hostilities. Oil prices are rising and the Strait of Hormuz is closing again.
The energy industry warns that much of the released reserves have now been depleted.
Financial markets are ready to test the Fed Put, even as Main Street prepares for possibly more adverse economic outcomes.
As Iran and the US resume hostilities, markets and businesses are looking towards the energy industry wondering what comes next. For the economy, the news isn’t great. As reserves are depleted, we are approaching more adverse economic scenarios of an economic spillover into 2027. Markets, however, much like in the pandemic, are increasingly looking towards the US Fed for support, and Kevin Warsh is preparing for his first big test.
Despite initial hopes that the two combatants had been worn out by the loss of infrastructure (the Iranians) and ammunitions (both), both sides seem eager to resume the fight. The prize? None other than control of one of the world’s most important maritime chokepoints, the Strait of Hormuz.
Iran made it clear that it would not allow the return of the previous status quo, the free passage from Hormuz. Why? Because in exchange for a fee, it would risk more attacks.
In this fight, Iran, clearly the underdog, has three cards to play. One, a large standing army, which would make a land incursion costly. Two, its proximity to the Strait, allowing it to essentially control all traffic through it, and three its nuclear capabilities. The third card (nuclear) is potentially a future one. The first card is purely defensive and works insofar the US is weary about the potential bodycount.
The second card, control of Hormuz, allows it significant geopolitical leverage. The longer it controls it, the closer the global economy comes towards an energy crisis. This is why it could practically not allow for full traffic through Hormuz during negotiations, without some quick wins. Because it would allow the global economy to reset the clock, significantly reducing its leverage. The Iranian leadership would have to endure many more months of bombing before its leverage reached the exact same point where it is today.
As long as the US doesn’t allow Iran control of the Strait, the conflict will likely persist. The question in everyone’s lips is: are we getting closer to a crunch point, beyond which the repercussions for the global economy become exponential.
Yes, we are. The International Energy Agency said last week that its member countries had released almost three quarters of the planned 400mn-barrel emergency stock release. Thus, there are only a few more weeks to go before those supplies to the market dry up.
The reason behind the relatively quiet spring, despite the geopolitical turbulence, was excess reserves plus lower demand from China. These are now being depleted.
Oil prices are once again pulling up, putting an onus on global household consumption, making travel more expensive and possibly further limiting the fiscal space of governments who will want to absorb some of the shock.
In an interview to the Financial Times, Amrita Sen, director of market intelligence at Energy Aspects, said that before March, the oil market had about 400mn barrels of excess inventories, not including strategic reserves controlled by governments. “Now we have close to nothing,” she added. Adding more pressure on the Energy market, Ukraine’s successful attacks on Russian refineries is further limiting gasoline supply.
Yet, equity markets are at, or near their all-time highs and bond markets aren’t pricing in any sort of short-term inflation shock. Is that optimism predictive of good outcomes?
We don’t believe so. Markets are not good at geopolitical or economic forecasting, at least to the point where the economy is also a political function. Investors know how to forecast corporate profits (with significant help from management) and possibly price the risks of corporate bonds (a very small number of which actually default). As a whole they are not equipped with a mechanism for pricing geopolitical risks.
Having grown accustomed over sixteen years to buying every dip, with the help of the Fed, shorter-term investors always look for a reason to justify this tendency. Thus, a tweet from the US President is enough for them to price in the end of the war. And this is what they do, despite the obvious problems, the unpredictable leaderships, and the negotiating uncertainty on both sides.
There is one simple truth: equity and bond markets aren’t pricing in long-term disruptions in Hormuz. Implicitly, the bet on the Fed to absorb market risk. Their behaviour is reminiscent of 2020.
In the spring of 2020, the world was preparing for the shock of Covid-19. We knew it was already crossing from China to Europe. Yet, the markets were in a holding pattern. With the first death in Italy, global stock markets declined dramatically. Why was that? Since it had arrived in Europe, wouldn't we have had deaths?
It is because investors consider that even a global energy crisis may be somewhat managed by an accommodating US central bank. After all, it successfully managed the Covid-19 pandemic. In 2020, the US market lost 40% of its value, but recovered in a record 16 days from the trough, as the Fed intervened with fresh Quantitative Easing. Markets will likely remain calm until an event happens, for example governments taking measures such as rationing gasoline, or limiting transport.
The next step in the playbook
Like in 2020, markets will again look to the Fed. A new, and theoretically more hawkish central banker will have to judge whether the central bank needs to prioritise its role as a lender of the last resort (the Fed Put) or whether it’s more important to stick to a narrower mandate of inflation fighting.
The answer, to a question not yet asked, but to be, will determine a lot.
The impact of a non-market-friendly response from the Fed could only partially be mitigated by the ECB, and that is only if Italian and French yields come under pressure. Beyond these two central banks, markets don’t have many safeguards.
Now our base case scenario, a muddle-through, for all the pressure its is receiving, remains unaltered. We don’t believe that there is a significant probability that Western militaries will sit idle as Iran sinks the global economy, increases friction in financial markets and compromises the central banks’ ability to fight inflation. But, to justify what would likely be an intervention with casualties, the pressures on western electorates would have to become more pronounced. Which is the way we are headed.
What it means for businesses
Energy is important for businesses. If governments feel that friction is necessary to justify military intervention, then we could see some disruption going forward, be it limits on energy use, higher energy prices ,inflation, or even mandates for working-from-home. And just like in 2020, it would be a good time for operations managers to review and update the relevant procedures.
What it means for investors.
For a crash to happen, a number of things would have to go wrong simultaneously. Iran successfully limiting traffic through Hormuz, western governments sitting idle or failing to provide safe passage, and the American central bank refusing to inject markets with liquidity at times of significant stress. While we can only surmise peoples intentions, we would bring attention to our first comment, that “markets are not good at geopolitical or economic forecasting”. Investors thus need to maintain caution and, with any spike in volatility ,ask themselves what is the probability that all the above factors would go wrong at the same time.