Tatton News Archive

Latest news from Tatton Investment Management: Why are markets so calm?

4 October 2024, 12:00am

Raised tensions in the Middle East have dominated the headlines this week. Capital markets are obviously not the most humanly important consideration in this situation, but our job as investment managers is to think about how they might react. Initially, global stocks sold off slightly after the news, while oil prices gained 5% from the year’s lows. The dollar recovered about half of its recent decline against almost all currencies. But overall, compared to history, we would characterise this reaction as surprisingly mooted.

We had more oil price gains this morning, once it became clear that Israel wishes to target Iran’s oil production. The US dollar gained – usually a ‘risk-off’ sign from markets. But low-risk US treasuries are down in price, while higher risk assets remain in demand. One might think this a counterintuitive response.

It is only counterintuitive if one thinks the recent growth signals from the US and from China will be overwhelmed by the Middle-Eastern impacts. Markets clearly think this is unlikely. Today’s US employment data suggests the labour market is strengthening, while there are reports of strong consumer spending during China’s current week-long holiday.

On balance, we did not and do not expect that the Israel-Iran conflict will have long-lasting impacts on asset prices. Currently, markets are more preoccupied with global growth and monetary policy and, in that respect, the outlook has continued to improve this week.

Oil prices are full of uncertainty, but supply is plentiful.
In general, the lasting market impacts of Middle Eastern conflicts come through oil prices. The oil shock begun by the Yom-Kippur war of 1973, and consequent Arab oil embargo on Western nations, saw a 400% rise in crude prices. In the last 30 years, there have been two major global conflicts that caused oil prices to spike: Iraq’s 1990 invasion of Kuwait, and Russia’s 2022 invasion of Ukraine. The Gulf War spike was short lived. The Ukraine war has had a longer impact and restructured global energy markets, but this has mainly related to natural gas. Oil prices returned to ‘normal’ in less than a year.

We would caution any direct historical comparison, however. A full war between Israel and Iran would be a different story, particularly if it coincided with a Saudi-Iran conflict. US President Biden cautioned Israel against targeting Iran’s nuclear sites, but is reportedly considering backing Israel’s plans to hit oil refineries (Iran is OPEC’s third-largest producer).

We are not oil experts, but there are clear risks for global oil supplies. Still, that risk needs to be seen in the context of the current global oil oversupply. Saudi Arabia is loosening supply constraints, supposedly to regain market share that it lost to non-OPEC producers and less disciplined OPEC+ members. Libya’s political situation has recently allowed its oil supplies to come back onto the market too. All of this is happening while global oil demand has been sluggish. We were fairly confident that oil prices would stay subdued for those reasons, before the recent escalation. Tensions this week introduce uncertainties, but probably do not change the fundamentals too much.

Monetary policy getting easier – but will it work the same?
As usual, markets are more preoccupied central banks. We have known for a while that the US Federal Reserve is dovish (preferring lower interest rates) but this week we got encouraging signals from other central banks. Bank of England (BoE) Governor Andrew Bailey said on Thursday that rate cuts could get “a bit more aggressive” if inflation pressures keep coming down. Sterling had previously been strong, as markets thought the BoE was more hawkish than its peers (higher UK rates encourage people to keep their money here, pushing up sterling) but Bailey’s comments sent sterling down more than 1% against the dollar.

Markets are also betting on another European Central Bank (ECB) cut this month, after ECB president Lagarde expressed increasing “confidence that inflation will return to target in a timely manner”. Meanwhile, Japan’s new Prime Minister Ishiba seemingly pressured the Bank of Japan into maintaining its near-zero rates. In general, global central bankers seem confident that inflation – particularly wage inflation – is now contained, and policy can become more supportive. That is good news for global liquidity.

We are positive about this, but would add a note of caution about liquidity. Ever since the 2008 global financial crisis – and particularly during the pandemic – we became used to the quantitative easing style of central bank liquidity creation: flooding the system with money by buying bonds. That is clearly not happening now (in fact the opposite, quantitative tightening is still in force). Liquidity creation now is more old fashioned: ease financing rates and let the commercial banks create money themselves. The banking system is not what it was, so the transmission of liquidity might not be as strong. Still, this is a positive for the economy and risk assets.

But the US economy may be too strong for the Fed to remain dovish
Even before China’s new policy stimulus, global and regional financial conditions had eased considerably, benefitting the economy. This is most apparent in the US, where the September employment report showed returning growth. Economists expected a moderate increase in the US non-farm payroll (the nation’s standard jobs measure), adding an extra 150,000 jobs. The actual increase was 254,000. The non-farm data often produces surprises like this, but it was meaningful all the same. Unemployment fell back to 4.1% from 4.2% and average hourly earnings grew 4% year-on-year.

These data are clearly stronger than the previous few months and confirm what the more patchy employment data had already suggested: the recent soft patch bottomed in the summer and confidence is growing. Pay growth has stabilised and is ahead of inflation, supporting consumption into the year-end.

Fed chair Jerome Powell spoke earlier this week, saying interest rate cuts would be moderate (as we predicted last week, contrary to market pricing). Bond yields rose after his comments, and again following the employment data: 10-year yields are back near 4% and markets now expect the Fed funds rate to end 2025 at 3.5%, versus 3.25% last Friday. But markets think rate cuts are still on the table – as the non-farm payroll often moderates after positive surprises.

Commentators talk about “soft-landing” where the economy settles at a sustainable level, then trundles along. The US may have already landed so softly that we didn’t feel the wheels touch the ground. If so – absent energy inflation shocks – today’s strength in risk assets is entirely justified.