When the Middle East conflict began in October last year, the conventional wisdom was that nobody had an incentive to allow this conflict to spread to the rest of the region. Since then, we have had a series of minor escalations. In isolation, none of them seem that significant. But collectively they add up to a significant broadening of the conflict. Does this mean something will happen that will lead to a sudden re-evaluation of the outlook for growth or inflation?
I am reminded of the concept of ‘fingers of instability’. This describes the situation where if you add a grain of sand to a sandpile, it is unlikely to lead to a significant change in the structure of the sandpile. However, if you do it long enough, then it will create fingers of instability in the sandpile such that, eventually, just one additional grain of sand causes an avalanche. This is an example of a non-linear relationship – each grain of sand has no perceptible impact until suddenly one does.
Markets can act in this way. Things happen smoothly until one, seemingly insignificant, piece of news has an outsized impact on financial markets. As I have been traveling and speaking to clients in the Middle East in the early part of the year, I have been thinking more and more about the regional conflict. Of course, the humanitarian consequences of any conflict are always the most important. However, it is my job to try to figure out the implications for financial markets.
Throughout, the major powers have been arguing against a broadening of the conflict. However, actions have not been aligned with this objective, so far. We have seen grain of sand after grain of sand dropping onto the sand dunes as each minor escalation is followed by a military response. An avalanche is by no means inevitable, but the possibility is something investors need to factor into their investment allocations.
So far, equity markets have taken everything in their stride, with US equities making an all-time high and global equities approaching their end-2021 peak. For bond markets, yields are off their lows of late December, but they are far from the levels seen when the conflict began.
For me, the impact of the conflict on global growth and inflation is critical. The reduced willingness of shipping companies to sail ships through the Red Sea and the Suez canal – due to the Houthi attacks on shipping lanes – increases the risk of the regional conflict having global consequences.
From a growth perspective, the re-routing of trade via the Cape of Good Hope around Southern Africa will lead to significant delays in the flow of goods around the world. Meanwhile, the increased transit times and distances will increase costs, and thus inflation.
This is, therefore, stagflationary. For those with scars from the simultaneous sell-off in bonds and equities in 2022, stagflation is a scary word. It basically means growth is stalling and inflation rising. Slower growth undermines corporate earnings, while higher levels of inflation mean central banks cannot ease policies significantly to support the economy. High levels of inflation, therefore, can lead to a positive correlation between bonds and equities.
In 2022, this was clearly a bad thing, resulting in the worst combined equity-bond performance in 150 years, outside of the Great Depression year of 1931. At the beginning of the year, we argued the equity-bond correlation is likely to remain largely positive in the first half, but in this instance, it was deemed to be good for investors as bonds and equities rise together.
However, if we get an upside inflation shock then investors would likely face losses across their portfolios again. The spike in the ‘manufacturing prices paid’ index from the US Institute for Supply Management is worrying from this perspective, although it is important to note that this is a volatile series and service sector inflation looks highly likely to decelerate in 2024, which should offset any blip in goods inflation. In my opinion, the broader disinflation trend is likely to be challenged only if we were to see a sharp upside move in oil prices above USD 120 per barrel.
So how are we approaching this environment. We are keen not to over-react. The central scenario is that everything will play out broadly as anticipated i.e., the ongoing global disinflation should enable global central banks to start cutting rates later this year to support growth, lifting both stocks and bonds. However, we have taken advantage of the rally in equity markets since late last year to trim our allocation to US equities within our foundation portfolio, while retaining a smaller overweight allocation. We have also added an allocation to inflation protected bonds as a hedge against any upside inflation surprise in the short term. We also continue to allocate to hedges in the portfolio, including infrastructure, gold and liquid alternatives, as these should offer significant diversification benefits should investors start to question the disinflation story.
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