“Back to square one”

“Back to square one”

The geopolitical saga hasn’t stopped surprising the market and even with a signed memorandum of ceasefire, war operations between the 2 counterparties are up and running in an active manner. Hence, in terms of market expectations we are “back to square one” with more meaningful moves in the price of oil and overall drawdown in risk assets.

But let’s look at what is going in the market. Approximately 10 days ago President Trump took a very hawkish view with regards to the path of negotiations, and this stance was apparently triggered in response to Iran trying to take control of the Strait of Hormuz. This seems to be the never-ending issue between the 2 countries, and they haven’t even come to discuss the major issue, yet, which is nuclear power. The US administration has taken the view that by bombing infrastructure facilities will enable them to bring Iran back to the negotiating table with an upper hand. On the contrary, Iran seems to be deterred by those actions and has begun attacking US bases in neighboring countries. Moreover, as of last night the US president has said he is considering an escalation in the war tactics if Houthis join the war, used to push the nation of Iran to negotiate a peace deal. So, in simple terms, both parties are trying to negotiate a peace deal through a war, an oxymoron statement!

The first initial reaction of the market was expressed through the usual suspects. The price of oil on the front contracts has risen 14% this week along with rates across both sides of the pond taking a move wider. What is more important is that inflation expectations keep rising despite the economic data showing a better-than-expected path. As of now, the US is pricing 42bps of rate hikes by year end with a live meeting on the 29^th of July. (see below table)

Post the ECB meeting, president Lagarde has opened the door for another 25bps rate hike in September with the market pricing 45bps of hikes by year end. In terms of market moves, 10yr yields across different countries have widened by 30-50bps year to date, a significant drawdown in % terms. On the equity side, we have seen a meaningful drawdown month to date, with technological indices under-performing and Nasdaq trading 6.7% lower. Across European indices and with renewed worries around the Strait of Hormuz, we have seen 1-2% drawdowns but so far it seems that the damage has been more contained versus consensus positions. It must be noted that we are in the middle of the earnings calendar, which has shown a very promising start in terms of beating market expectations. It is obvious that along with summer illiquidity, the market is assigning a higher risk premium in equity valuations as geopolitical fears build in. Moreover, on the commodity side, Gold seems to oscillate around $4k per ounce which is a well-defined support level. EURUSD keeps trading in a tight range of 1.13-1.1450 and it is expected to maintain those levels, ceteris paribus.

Looking ahead…

We are in the middle of the earnings calendar, which for now is beating the already high expectations of analysts. As we have seen month to date, this is not getting priced in in the equity valuations as more risk premia is embedded in the market due to geopolitical fears. Hence, we can conclude for now that the single most important factor to watch is the Middle East conflict which can be as unpredictable as it can be. We respect market technicals and have the tools to utilize any dislocations across risk assets. Active management hasn’t been as important as before and the “surprise factor” is sustained at elevated levels.

Written by: Michael Konstantinou, Head of Portfolio Manage