Deadlock of Hormuz

The ongoing war affairs seem to be keeping the market on edge.  Risk appetite has improved despite the war deadlock we are all seeing in front of our eyes. The real question still lies if this risk momentum is a result of market technicals or improvement of underlying fundamentals. We believe it is a mixture of both factors.

The month of April, on a seasonal factor, is a strong month in terms of equity returns. This month we saw a reversal in risk momentum in equities with a move of 5-10% on the upside. The main drivers of this out-performance were an array of earnings coming through that were better than the market expected and institutional clients adding exposure to the tech sector. The equity rhetoric shows now that US equity allocation is preferable as there is less oil dependency and hence lower marginal cost due to the high price of oil. Europe and Asia seem to be the most exposed and hence the recent under performance. We have seen Germany as a matter of fact, revising annual GDP growth from 1% to 0.5%. ECB speakers have not yet mentioned any growth concerns, and they are inclined to see what the impact on inflation will be. As of today, market expectations regarding ECB rate hikes is still pricing around 2.5 rate hikes by year end (66bp).

The market still seems quite confused and if you look at how government bonds have behaved in the last month, there is still a significant drawdown in % terms versus other markets such as equities. Both markets show a different story, the fact is that in the real world the Strait of Hormuz and by default the oil distribution to the respective countries is under a complete deadlock. As we have seen in previous wars and as was the case with the Ukraine-Russia war, the equity market is the first to react on a positive way as there are a few narratives that can persuade participants to join the risk on momentum. First and foremost, as we have seen in 2023-2025, is that the equity market can be a hedge against inflationary pressures. Secondly and in this case more relevant, as stock valuations go down and forward guidance in earnings keeps an upward growth, then we face a situation of forward price-earning valuations diminishing and creating better entry points in the equity market. Now all these can work in theory, with a big caveat that in some situations where global growth concerns start to prevail such as was the case in COVID, then we can see a deep repricing lower in the equity market. As of now, we haven’t seen or tackled any concerns across the globe; of course, that could easily change if more data leads to that conclusion. At the end of this week, we saw the first PMI data out of Europe with the Eurozone composite PMI coming at 48.6 versus an expectation of 50.1. The market did not attach a lot of gravity into the number and there was minimal price action across rates and equity markets as for now this is regarded transitory and reflected as the early cost of war. In terms of price action, German 10yr government bonds are anchored around the 3% levels, 40bps wider post the war and US 10yr government bonds are trading in the 4.3% context. Peripheral spreads are still under pressure but with positioning around Italy showcasing a more balanced holding. In terms of equities, European markets have risen in price but in the 4-6% context versus US markets which are trading 8-10% higher in the month. You can account for that difference due to the AI out performance which accounts for a high % in terms of weight in S&P. Gold futures have traded in a tighter range, currently oscillating in the $4650-4750 context. EURUSD is well anchored in the 1.16-1.18 range for now, as macro concerns are still leading to some upside for the USD, The price of oil is quite volatile with differentiation in expiries on future contracts which has led in a huge backwardation (front-end duration contracts trading higher than longer duration contracts). Brent Crude oil April futures are wrapped around $107 which is a 17% increase this month alone.

Looking ahead…
From here and going into May, where seasonality factors change to a more bearish appetite (“Sell in May go away”), the most important factor is geopolitical risk. We can be more intellectually curious and try and look at second order effects from the spike of price of oil, but first we need clarity of where this deadlock is heading as on both sides of the outcome distribution there can be meaningful moves across the market. Moreover, we will keep an eye on how forward guidance is heading out of earning’s season and if corporates have started to model the “cost of war” in the operational models. Lastly, any data across the pond which provides more clarity with regards to inflation and growth will be key to the market. Next week, we have all the central bank rate meetings which can be “live” events especially in the case of ECB and BOE. The language the central bankers will use will help to anchor any further inflation/growth expectations in each geographical region. Have a good weekend!

Written by: Michael Konstantinou, Senior Portfolio Manager