Warzone Affairs

The last 3 weeks the market’s focus has been entirely 100% devoted to the Middle East warzone affairs. There has been a 180 degree move in terms of market expectations and the drawdown in risk assets has been enough to cause de grossing and mark to market pain, at least for now. Saying that and looking at history, volatility brings opportunities as dislocations in the market take place in times of distress and when uncertainty peaks.

But let’s see how the market has reacted so far. It is a fact that currently with the social media frenzy that exists, geopolitical risk gets amplified as there is news coming across different directions which may or may not be true. Also, it seems that both sides (US & Iran) are trying to manage the market’s expectations and their own leverage by default, using media outlets which makes it even harder for market participants to evaluate valid information. As with many markets operating in a crisis mode, uncertainty levels keep elevated and dislocations arise.

Drawdown has been obvious throughout the month of March as the market had to digest, evaluate and re-position itself and its expectations based on a very different starting point. The first two months of the year seem to be an eternity away and if you look at how market expectations have evolved, it is not very far from reality. First and foremost, inflation expectations have been re-racked higher as the price of oil has almost doubled in 3 weeks. As a result, rate-cut expectations have been reversed into rate hike with the market pricing 81bps of uplift in the ECB deposit rate by year end. (see below graph)

On the Federal Reserve side, which was pricing two 25bps rate cuts by year end, is now pricing 15bps of rate hikes. The reversal of rate cut expectations to rate hikes has caused a move of 45-50bps wider in the core government bond market with front end contracts under performing and bear flatteners taking place. As you would expect, this was a violent move on a % basis as it happened too quickly causing stop losses across levered up market participants. On the peripheral countries in Europe, Italy was the under performer and as of now 10yr rates are trading above 4.1%, a 60bps move in the last month. On the Treasury side, 10yr government bonds are wrapped around 4.48% with a tight print of 3.93%, 3 weeks ago! The market is watching very closely the 10yr US government yields as this is a pressure point for the US administration given its elevated US budget deficit.

On the equity side, the drawdown was more significant in European and Emerging markets as this was a high conviction trade for participants given the underperformance versus the US. Price Moves oscillate from 12-17% from peak to trough with Chinese and German indices underperforming. In the US equity indices, we have seen a 6-8% drawdown for now, as the market is differentiating from producers versus importers of oil. In credit, crossover derivative indices are 100bps wider with cash outperforming given the rates move. So far, credit is clearing as the market for now is worried about inflation but not global growth. If this situation prolongs of course, the narrative can easily change with higher probabilities of recession starting to price in the market. On the commodity side, which for the last few years provided a great diversifier, the story was mixed. Obviously, the winner of the month has been oil with a 50% month to date, bringing year to date returns to 100%. On the gold side, we saw a 16% drawdown for the month bringing year to date returns to almost flat. There is a lot of speculation about why this is happening as gold should provide some kind of safety in high geopolitical risk situations.

Looking ahead…
In markets where there is high uncertainty, a prudent risk management measure is to raise cash, something which we have adopted across our strategies and portfolios in the last 3 weeks. This creates a buffer which is ready to be invested. Currently as it stands, the market’s focus is towards the current geopolitical risk. We have read multiple iterations and probable results so far with game theory practitioners attaching several probabilities to different scenarios. No one can really say when or where this conflict will lead but if history serves as a guide, the market will most probably price the worst-case scenario fast and with no remorse. That’s where overshooting takes place and that’s where opportunities arise. It is much more difficult to do in practice than said, but with a diversification perspective there will be eventually good opportunities to be taken. But for now, we await how this weekend will play out as we have done for the last 2 of them!

Written by: Michael Konstantinou, Senior Portfolio Manager