Fluid Ceasefire

Fluid Ceasefire

Geopolitics never seem to stop surprising the market as in the last few days, we saw another narrative reversal of ceasefire conditions into fears of escalating war. President Trump very categorically criticized the Iranian regime and its stance towards the control of Strait of Hormuz.

The US military struck Iran for consecutive days, hitting about 90 targets to further degrade the Islamic Republic’s ability to attack ships in the Strait of Hormuz. The Iranian regime responded by targeting US bases in Bahrain, Kuwait and Qatar and has made it clear that there is no compromise to be made. In a nutshell, we are back to square one, irrespective of the memorandum that has been agreed and signed by both sides. The market was obviously surprised and so far, it is experiencing a minimal drawdown with fixed income suffering the most. But let’s look at the consequences of this unexpected event and what that implies for the market.

First and foremost, the market is efficient enough to understand that there are some negotiating and leverage tactics embedded to this change of stance, hence the drawdown is contained, at least for now. The asset class which tends to underperform is on the rates side where government bonds price in a very abrupt manner, a higher number of hikes as inflation expectations get anchored higher. In this case, Italian 10yr government bonds are 20bps wider week to date, in line with 10yt German government bonds. On a % basis, the drawdown is way more than what the equity market is experiencing, as different factors may impact the latter. Secondly, the price of oil was obviously the most impacted one with a rise of 8% with Brent Crude front contracts wrapped around $79, still a long way off the highs. On the equity side, European equities underperformed as the fear of closure of the Strait of Hormuz has a bigger impact on the continent. Drawdowns reached 2-3% with German indices underperforming. In the US, we had a move of 0.5-1% lower with technology sector rebounding and by default supporting the market. Gold has traded in a range of $3950-4250, currently at $4100 per ounce with the EURUSD sticking to its tight range of 1.135-1.145, for now.

Let me remind you that we are in the second week of July, seasonally a positive month for total returns. We are also one week away from the start of the Q2 earnings season with very high expectations embedded in the market. Hence, escalating events which add to negative market tail risk, along with summer illiquidity, may cause asymmetrical moves on both sides. From our perspective, this brings out some cheap bargains, especially on the Equity side, as we still think that the fundamental growth background will be able to persist the current geopolitical risk. It will be very interesting to see if rational heads prevail and there is some de escalation going into the weekend.

Moreover, post-the-month-end selling technical of technology and memory chip companies, we are now experiencing a reversal of flows. Positioning seems a bit cleaner and there are decent inflows entering that part of the market from global funds. We are in the camp that believes that this is the start of the cycle and that increased capital expenditure will contribute to overall growth in the world economy. On an idiosyncratic level, investors should be careful with their stock picking but in a more holistic view, we are experiencing an evolution of how companies and processes will operate with a certain positive productivity outcome. We are still navigating through certain bottlenecks such as memory chips and AI infrastructure, but the pace of this evolution is so fast with new solutions coming up on a dynamic basis. We are sincerely looking forward to seeing how and in what way all this new technology will be implemented in different industries in a meaningful way and how that will impact the world economy.

Looking ahead…
As we already mentioned, we are going to start slowly seeing Q2 earnings coming up as the market expects a 22% growth versus last year. More importantly, with the recent correction in the semiconductor space, it seems that more inflows have taken place and has created a more benign market technical for further upside. Options flow remains on a net index positive gamma basis, with upcoming US CPI data announced on the 14^th of July. This is a very important number post, the last US NFP number that came lower than expected. If we get a benign print which might further alleviate inflationary fears, then we might get the seasonal set up for net positive total returns, ceteris paribus. Of course, there are a lot of moving parts given the current geopolitical risk, earnings calendar and economic data announcements; hence we are in for a volatile month/summer!

Written by: Michael Konstantinou, Senior Portfolio Manager