A few weeks back Henry asked me if I could step in and write this month's blog as he would be out of the office. "Sure, no problem", I said, anticipating writing about inflation continuing to ease and the possibility of a Bank of England rate cut. How difficult could it be? Oh. If ever you doubted Henry's foresight into markets, think again!
Fears around AI and some isolated private credit events had put us on what Henry called the rollercoaster last month. Since the first strikes on Iran, that rollercoaster has been made to feel more like a children’s ride than the Space Mountain-like ride we are now on, with few people seeming to know which direction we’re heading in from here, or when.
When events like the war in Iran come along, pretty much out of nowhere, I like to make sure we don’t get so focussed on it that we ignore other factors affecting the economy. But right now, it is difficult to see anything else playing a majority hand in things for the foreseeable future. The caveat of course is that, given the players involved, the foreseeable future is a short period of time; so much so that what you’re about to read might be outdated despite being written just a few days before publishing. That is why you won’t find me quoting many real-time prices, more just my thoughts on the direction of travel.
As I’m sure it won’t have escaped you, one of the biggest problems to come out of this war for the global economy is the lack of ships passing through the Straits of Hormuz. The pair of two-mile wide channels which allow access to the Persian Gulf carry around 20% of the world’s total oil supply, 80-90% of which goes to Asia. The world’s largest LNG field, in Qatar, also has its export route through the Straits, while around a third of the world’s fertilisers also travel that waterway, according to Kpler. (WSJ)
So just when it looked like central banks were starting to get inflation heading towards their targets, a sharp about turn appears to be on the cards when the data for March starts to flow through. It is also rendering irrelevant much of the data we have seen so far this month, as it was reporting on a very different set of global economic conditions.
WTI crude oil was trading around $60 in February; it is now trading above $90, having touched $100 on several occasions so far in recent weeks. Brent crude has seen a similar shift from $70 to above $100. (MacroTrends) The price of gas in Europe has also roughly doubled. All three are basic input prices that affect almost all supply chains globally, be that cost of production, shipping, retailing, or any combination thereof. With global growth, ex US, struggling before the war, stagflation is back on the buzzword list.
And gold, the historic safe haven, has seen its year to date gains wiped out, most likely in my opinion as holders need liquidity to cover margin calls. Cash is king at times like this.
I could have written this whole blog on risk, given the level of uncertainty we are seeing across global markets. The biggest uncertainty having the largest effect is the duration of the war in Iran. At the onset of strikes, talking heads on news programmes were talking in terms of weeks. As I write this, we are less than a week from the first month being clocked up. And despite the US offering insurance for ships passing through the Straits of Hormuz and Donald Trump’s calls for a united fleet to escort vessels and protect them from Iranian attacks, there still seems no resolution of Iran’s blocking of the Straits. While that remains in place, it seems inconceivable that an end to the conflict is near. But if we’ve learned anything from recent months and years, the obvious can quickly become questionable.
Yes I did say the war is the majority factor in considering risk currently. But that isn’t to say it is the only one. The AI risk remains. Equity valuations for any companies linked to AI remain around 10% down from their highs. The S&P is more than 4% down year to date, Nasdaq around 6%, a directional shift replicated across many other indices around the world. Elevated energy prices aren’t going to reverse those moves any time soon. (CNBC)
I’ll come to the risk of rate hikes below, as central banks try to fight that inflation, while the hits in private credit continue to come. It may still be a tail risk event, but one that feels like it needs growing scrutiny.
The demand for credit was at a record high coming into March: the year to date issuance volume for the first two months of the year had set a new record and another record year seemed likely. Spreads remained close to all-time tight levels. But the war in Iran was a shock that not even the credit market’s resilience could withstand. In the US, investment grade credit spreads have doubled since attacks started, while European spreads have roughly trebled.
However, any window of steadiness offered to investors has been grasped. Amazon was the largest beneficiary of that latent demand, selling $37bn of bonds in the US and €14.5bn in Europe in 24 hours during the second week of the war. This is one market where demand will resume almost as soon as any end to the conflict is announced. (FT)
The same may not be true for private credit however. The market has shifted from isolated cases of default to material portfolios being written down and resulting in funds limiting withdrawals. The war may be a catalyst for further writedowns and more stress on high yield issuers’ businesses and their ability to refinance with rate jumping higher.
The ECB held its deposit rate at 2% in March, while acknowledging the uncertainty the war in the Middle East has created. The accompanying statement said the war will have a material impact on near-term inflation but pointed out that the ECB’s aim is to stabilise medium-term inflation at its 2% target, something that the bank had been achieving, forecasting inflation at 2% in 2027 and 2.1% in 2028. (ECB)
The ECB may consider itself lucky that its most recent meeting came close enough to the start of the war that they could hold rates and buy themselves a month to hope that the war ends, or at least some conceivable pathway forward can be constructed.
But markets don’t have that luxury and we have seen the short-term rates climb significantly higher. At the end of February, the expectations for ECB rates were in single digits for the whole year. In just three weeks, the expectation for year-end has climbed more than 50bps, to over 2.5% to combat the inflation fed through from this period of heightened energy costs. While coming from an admittedly low base in terms of growth, it did seem that the EU was starting to turn a corner. This conflict could set that back again.
Of course, the ECB is not alone in this difficult position.
The Bank of England also held rates, also alluded to the risk of inflation from the Middle East conflict, and the published comments from each member of the Monetary Policy Committee gave us insight into their thinking. Catherine Mann said she was considering a hold “or even a hike”. Swati Dhingra, for so long one of the more hawkish members of the MPC, said a rate rise could be warranted if disruption is long lasting. But Deputy Governor Dave Ramsden said he would have voted for a cut if not for the Iran war. (Reuters)
The market had been pricing in a cut as early as April before war broke out, with another more likely than not before year end. But the rising oil and gas prices have seemingly hit the UK harder than its continental counterparts and rates have moved even further.
Immediately post the meeting and Governor Bailey’s press conference, the market was pricing in three hikes before year end. So severe was the leap seen, it prompted an unusual follow-up comment from Bailey, cautioning against "reaching strong conclusions about us raising interest rates.” He did have the effect of the three priced-in cuts being eased to two, but in recent days as hostilities ramped up again we’ve seen short-term rates whipsaw, making it dangerous to even write here what the current move is. Needless to say, rate hikes are expected, growth will be further subdued (the latest reading showed an economy flat-lining) and the Chancellor may have to eat into her fiscal headroom to try to ease some of the pain for consumers, but that headroom is already being eroded by the rise in the cost of borrowing.
There is no data yet, but stories are already emerging of hits to the hospitality and travel industries as consumers tighten their belts for both an increase in the cost of goods and higher mortgage rates.
The US’ own oil and gas supplies mean it hasn’t had the hit to input costs that other countries have as a result of the conflict. But the cost of imports will rise, even if the cost of domestically-produced goods don’t just yet.
The Fed had been seeming to focus on protecting the labour market at previous meetings, using it as justification for rate cuts while inflation remained around 50% above target. However, when the minutes of the February meeting were published they showed the FOMC was worried about the path of inflation and the expectations for a full two cuts before year end was reduced to between one and two.
But just as the ECB and the Bank of England had done, the Fed held rates at its March meeting, acknowledged the further risk to inflation, and published a more concentrated dot plot. Normally a concentration of views on the dot plot suggests increased certainty, but for me, this is due to heightened uncertainty around which way the next move might be. The market has shifted its expectations like it has in EUR and GBP, but by lower magnitude. One hike is currently priced in, but as we have seen, market expectations shift from headline to headline.
Unfortunately, I’m coming back to where we started. It’s pretty obvious to me to say it all depends on how long the war continues, how long the Straits of Hormuz remain closed, and what the knock-on effect is if and when the war ends. It has to add a risk premium to many assets that weren't there before the war – we can argue whether that premium should have been there or not. But until we get clarity on an end game, markets will remain unpredictable and volatile. Not markets to try to get too clever in. Be sensible, stay safe.
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