Following the conflict in the Middle East over the weekend, Mutual Limited’s CIO Scott Rundell looks at how markets reacted overnight and the short-term outlook.
Macro themes
The impact of the conflict in Israel over the weekend on markets was somewhat predictable – a rally in government bonds as capital flowed to safe haven assets, but it wasn’t sustained. Other assets did very little. In early trading 3Y yields had fallen 12 bps and 10Y yields were down 8 bps within the first 15 minutes of markets opening. In after lunch trading, much of the gains in bonds had been given back, with 3Y yields down 5 bps vs the open, while 10Y yields are down just 2 bps. The ASX 200 opened higher from the get-go, seemingly ignoring rising geopolitical risk and instead reflecting solid gains observed in offshore moves on Friday night our time.
Market reaction has been somewhat predictable, crude prices rose, stock futures eased off a touch and treasuries rallied, but only some of these moves have stuck.
If the conflict escalates, with other countries entering the fray, then markets could wobble. An example would be sanctions on Iran – who have by all accounts helped plan the Hamas attack – which would have oil price implications. Worse still, Iran could be drawn into open conflict with Israel, either by their own initiation, or Israel attacks Iran because of their apparent involvement. Lebanon to the north is also at risk of being dragged into the mix.
While Israel is not an oil producing state, with middle east conflict, there is always risk of oil price surges reflecting potential supply disruptions. With the Russia vs Ukraine situation, and production cut backs from other OPEC members in recent months, oil prices has surged some 34% from June toward the end of September, before plunging 12% over the past two weeks. Since the weekend, oil has risen again, up 4%. Oil and energy costs in general are major contributors to inflation, so any sustained upward trend in oil prices on the back of this conflict will weigh on inflation expectations. Importantly, central banks generally look through energy price impacts because they are volatile, but sustained increases really can’t be ignored.
Stocks
After some initial softness on the back of the Israel-Hamas conflict, market attention – at least in stocks – pretty quickly swivelled macro dynamics and monetary policy expectations, with Fed officials signalling the bank will “refrain from lifting rates this year” (Bloomberg). Fed Bank of Dallas President Lorie Logan said the recent surge in long-term US bond rates may mean less need for the central bank to tighten again. According to Morgan Stanley strategists, the next risk to US stocks – and by extension AU stocks to a greater or lesser extent – could come from fiscal policy constraints at a time when the Fed is still fighting inflation. While the US government avoided a shutdown recently, just, “the lack of a resilient long-term structure that supports fiscal discipline” could have broader market ramifications.
Bonds
US treasury markets closed for Columbus Day, but futures were trading and they rallied, as did BUNDS, OATS, and GILTS, which is the action you’d expect in a conflict, and of course Fed commentary around potentially being done with rate hikes for the remainder of the year, possibly even the cycle, helped also.
Credit
Traders yesterday marked major bank senior paper +1 – 2 bps wider yesterday in response to Israel, leaving indicative 5Y senior at +93 bps, while major bank tier 2 was pushed +2 – 3 bps wider, with the WBC Jun-28 now at +198 bps. I understand why traders marked spreads wider, but don’t expect any meaningful follow through given light flows. Having said that, while the conflict has risk of escalating, I wouldn’t be rushing out buying paper at these levels with the view they’ve cheapened. If we see 5Y at say +100 bps or higher in coming weeks, then yes, that’s on the cheap side historically, but at +93 bps spreads are still in the neutral zone.
