Weekly Digest: Playing to the market conditions

I’ve just returned from my annual golf trip to Spain. Sometimes you find the ball in a difficult or awkward position. But the game has a simple rule: you play as the ball lies. It’s useful because you assess every shot on its merits and then get on with it.

There’s a lot to be said for taking the same approach to investing. It’s rare for a golf ball to be sitting neatly, with a clear view free of obstacles, and a gentle breeze behind you. 

Likewise, the stars rarely align to present investors with a stress-free opportunity to make attractive returns. But history shows that if you wait for perfect conditions, you’ll miss out on many of the best opportunities to grow wealth. That has certainly been the case this year.

Ripples from the Middle East 

The biggest source of uncertainty today remains the impact of events in the Middle East. Although the consequences of a restricted supply of commodities from the Gulf haven’t been as severe as feared, it’s widely recognised that the longer the Strait of Hormuz remains closed, the more the effects will be felt through raw material shortages, production disruptions and higher prices. That would affect inflation, economic activity, and monetary policy.

Unsurprisingly, markets have reacted positively to the latest news of an impending agreement between the US and Iran to extend the ceasefire. We’ve been consistent in our opinion that this was the most probable outcome. However, the risk of escalation has also restrained us from being more optimistic. 

Even so, it still feels premature to declare the ‘all clear’. One of our external geopolitical advisers has long argued that President Trump would reach a settlement within a few months, then return to ‘unfinished business’ after the mid-term Congressional elections in November. He could either gain a renewed mandate to put further pressure on Iran, or more probably, given opinion polls, lose control of Congress and act with no fear of consequences as a ‘lame duck’ President. 

While geopolitical analysts tend to emphasise negative outcomes, this isn’t a risk that we should dismiss. For now, the planned agreement removes an immediate obstacle. A deal is expected to lead to a re-opening of the Strait of Hormuz, and that has been reflected in lower oil prices. Brent crude is back below $80, having recently been as high as $120 a barrel.

By a quirk of timing, it’s where it was a year ago following a spike when Israel launched independent missile and air strikes on Iran. It hasn’t, however, returned to the $60-70 range seen before the current war. But it is now below the $82 average for the last five years. This period takes in the even higher prices reached following Russia’s invasion of Ukraine, but the global economy has managed to stay afloat. Some of the resilience was achieved through state-funded energy subsidies, and the bill for those is still being paid through higher interest rates on bigger fiscal deficits. 

But we aren’t unduly concerned by oil prices remaining higher than before, at least for a while, as strategic reserves and commercial inventories are rebuilt. Such supply-driven shocks tend to stimulate positive long-term responses and both households and businesses find ways to reduce overall energy consumption and switch to other sources, with renewables being a clear winner. 
 

Prices and rates

One area where the consequences will be quickly reflected is in interest-rate expectations. On the eve of the war, expectations were for the Bank of England base rate to be 3.25% by year-end, implying two quarter-point cuts. By mid-March that had jumped to 4.6%, implying three increases and perhaps a fourth. The Bank of England published analysis showing that the worst-case outcome, with the oil price spiking towards $200 per barrel, would require them to raise the base rate to 5.25% to head off ‘second-round’ inflationary pressure. This is where higher prices today drive higher expectations of future inflation and increased wage demands to compensate. 

With the oil price retreating, inflation expectations are falling too, as are future interest rate levels. We are now back to 4% being priced in for December. Although that’s still higher than in February, markets tend to respond more to the direction than the level of rates, so this shift lower is encouraging. 
In the United States, its relative insulation from the effects of higher global energy prices meant that the expectation of higher rates was never as extreme as in the UK. Even so, the three expected quarter-point cuts in the Fed Funds rate for this year have gone. 

Intrigue is added to the US monetary policy plot by the arrival of a new Federal Reserve chair, Kevin Warsh. His previous tenure as a Fed governor during the global financial crisis revealed him to be ‘hawkish’ (favouring higher interest rates to keep inflation in check). This time, he comes in with a more ‘dovish’ stance (more open to keeping rates lower) and emphasises the productivity benefits that may flow from the adoption of AI. But he also thinks that the Fed’s balance sheet is too big, and any efforts to shrink that will require a careful balancing act to maintain market liquidity. We’re withholding judgement until he makes his first official statement as chair. 

All in all, though, we’re reasonably confident that the possibility of lower interest rates slightly outweighs the threat of higher rates currently, and this is a positive factor. 
 

Filtering out the noise

My roommate on the golf trip was an old friend from university. His default option on reaching the room was to turn the TV to the BBC 24 Hour News channel. As long-time readers know, I find 24-hour rolling news a form of torture where every minute is treated as a make-or-break moment. And while there is undoubtedly some valuable content, it’s overwhelmed by the endless dissection of relatively unimportant events. Luckily, we didn’t need to spend much time in the room together (and I did request silence a few times). But it was a helpful reminder of the constant need to apply filters to the noise that so often assails us.
 

Crude cools as Hormuz tensions soften