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Armchair Generals

Despite having a background in Political-Economy we are careful not to speculate on topics where we have limited or insufficient information. The point here is to be careful reading too much into comments from armchair generals in the media. The world woke up on October 7 to a spate of attacks by HAMAS terrorists in southern Israel who indiscriminately targeted civilians, including kidnapping them in their homes and streets. The Western media has also focused on the failure of Israeli defence and US intelligence agencies. The broader geopolitical context is the potential conflict between Israel and Iran. While the US administration’s recent move to un-freeze $6 billion in assets for Iran is probably another catastrophic error of judgement. Beyond the distressing human implications, the key risk for markets would be if there was a broader coordinated attack against Israel by Iran, Hezbollah, Syria, and Egypt. The observations below focus on price and risk perceptions in markets.

Historically, conflicts involving Israel and its immediate Arab neighbours have not had a lasting impact on oil prices in this century. The plausible reason is that few regional powers have been interested in supporting Palestinians over Israel as they did in the 1970s and 1980s. That said, there is complexity given the recent negotiations between Saudi Arabia and the United States to normalise relations with Israel. The other areas of complexity are that Egypt is not supportive of HAMAS and Syria has been decimated by civil war.

From a macro context, markets have already been bullish oil. On the demand side, resilience in the US economy has under-pinned consumption. From a secular perspective, the global population is still expanding at a similar trend pace to history. Consensus estimates suggest oil consumption will continue to increase to around 107 million barrels per day by 2030. On the supply side, resources have been depleting fast and the cheapest oil to extract has been extracted. In that context, starving fossil fuel producers of capital has probably not been a very wise decision.

Currently, public listed companies contribute around 50% of global supply, but if future capital spending is constrained by the ‘Net Zero’ target and reduced supply from Russia, non-public companies (primarily from OPEC) will likely be required to increase supply. Capital spending from public energy companies have been in trend decline for the past decade (chart 1).

The bottom line is that the secular pressures have coincided with a potential supply-shock from the conflict in the Middle East. Furthermore, the US strategic reserve is near a record low. On the positive side, a sharp and rapid increase in energy prices can contribute to “demand destruction.” Historically, oil shocks have often occurred at extremely inconvenient phases in the macro cycle (chart 2) and energy-linked equities might have further relative upside in the event of an oil shock.

From a cyclical perspective, just as investors positioned “higher-for longer” the recent macro news flow has started to confirm the impact of the tightening cycle that started in 2022. However, as we noted in August, the deterioration in the macro news flow is only positive if the economy “soft lands” – that is the prevailing bias among fund managers according to the Bank of America survey (74% odds in September). It is also reflected in consensus earnings revisions which have trended higher again recently. Historically the odds of a soft landing are 2 in 12 since 1957.

The big picture risk is that the macro news flow continues to deteriorate leading to a growth scare, recession anxiety and a deeper correction in equities over the next few weeks. Counterintuitively, the rally in energy prices might not be a signal of macro strength but a signal of the end of the current macro cycle that has already been deteriorating from the lagged impact of policy tightening last year. As an aside, the MSCI World energy sector trades at a 65% discount to global equities on a free cash flow yield basis (chart 3).

From our perch, odds of a hard landing have increased, not decreased. We remain light and tight. The good news is that considerably more downside is priced in Asia and EM. The compensation for risk (risk premium) in US equities and credit is extremely narrow (non-existent) especially relative to duration-free risk in money market. Put another way, if the episode did lead to an oil price and Value-at Risk (volatility) shock, US equities and credit offer little compensation for risk. The consequences for fixed income are ambiguous, but the recent shift higher in long-end yields has contributed to a renewed tightening in broad financial conditions and probably sets up a bullish phase for fixed income at some point in the coming weeks.

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