Geopolitical tension, “higher-for-longer” interest rates and the Chinese authorities’ next move to boost flagging growth are among the uncertainties hanging over markets. We address your most frequently asked questions.
Q1: Why have global markets reacted modestly to the outbreak of war in the Middle East
A: Hamas’s October 7th attack on Israel was the deadliest in the nation’s history. While the scope of the war that follows remains unclear, little risk of a wider regional conflict has been discounted in financial markets at this moment.
What moves markets are events that catalyze a turning point in regional economies or the global economy. 90% of history’s shocking geopolitical events since World War II did not cause a collapse in the world economy (see Figure 1 in PDF below). The economic impact of most conflicts is regional.
According to top military and political advisors, neither Israel nor Iran will be in any rush to engage in a direct military conflict. The experts noted that Israel’s capacity to engage in a multi-front war was limited and that Iran had political and practical reasons not to provoke an even wider conflict. The defense support that the US has provided to Israel has been accompanied by extensive political activity designed to limit the geographic scope of the armed conflict. For now, this matches the conclusions drawn by global investors.
The Oil Wild Card
After a 4.2% jump in the global crude oil price on October 9, petroleum markets have calmed. Brent Crude oil – the global benchmark – is at $89 per barrel at this date. This is a full 10% below its recent high set in September. That said, Iran and Russia collectively supply 15% of the world’s oil. A disruption in supply could have a major negative impact on global markets, if sustained.
World petroleum supplies have both “concentration risk” and substantial political/geopolitical risk (see Figure 2 in PDF below). Petroleum and gas supplies are “consumable” products. But the US typically has just 30 days of finished gasoline supplies in inventories. US drivers consume 300 million gallons of gasoline per day, excluding diesel. This explains why oil prices are 25X more volatile than supply (see Figure 3 in PDF below).
With OPEC cutting production more than US producers have increased supplies, US/European energy producers are worthy portfolio additions. Their stocks are a source of income and may provide a potential hedge against shocks and inflation
Q2: Will Rates Stay “Stay Higher for Longer”?
A: While the US budget deficit has fallen by about 50% since fiscal 2020, net US Treasury borrowing will still grow by about $1.6 trillion this year. At the same time, the Fed has already reduced its bond holdings by more than $1 trillion through its “Quantitative Tightening” program.
A near 30% rise in crude oil during the third quarter contributed to a rebound in inflation, pushing the CPI up 3.7% from September a year ago. The US economy added 336,000 new jobs in September. These factors, plus large Treasury issuance and fewer foreign buyers, caused US bond yields to “break higher” in September. 10-year US Treasury yields reaching a cycle-high 4.8%.
The collective impact of all this on consumer borrowing costs is significant, to the point where some Fed officials believe no further rate hikes may be needed (see Figure 4 in PDF below). Like many other forward-looking indicators, business surveys are pointing toward slowing employment gains (see Figure 5 in PDF below).
If employment and inflation both continue to slow without an economic collapse, it is reasonable to assume the Fed will eventually reduce rates modestly. But in the event of a sharp rise in unemployment, the Fed is likely to move quickly to reduce its “restraint.”
Our base case is that employment growth slows sharply but doesn’t contract. We believe a pickup in productivity growth and less demand for services will reverse excess employment growth relative to GDP. This suggests long-term yields falling to 4% or less by YE 2024. If employment growth doesn’t falter at all, long-term yields will likely remain closer to 5%.
Q3: Should Investors Consider Adding Bonds? Equities?
A: Today’s bond yields have normalized to levels close to what we should expect going forward. The 2020’s “zero yield” world was an anomaly. Today’s yields are also highly unlikely to rise to 1980 highs either, a decade of 10%-per-year wage growth.
For bond investors, the sharp repricing of 2022 has greatly reduced fixed income investment risk. With coupons averaging above 4.5%, the average US Treasury total return over 12 months would not be negative even if rates were to rise 100 basis points (see Figure 6 in PDF below). Investors willing to take modest credit risk by buying investment grade corporate debt can earn in excess of 6% yields for the next 5 years, far higher than the Fed’s estimate of its policy rate over that period (between 2.5%-3.0%).
Turning to equities, we believe the correction in US markets is likely to end when investors can clearly point to the peak in interest rates. Our outlook for corporate profits – up 4% next year and +8% in 2025 – should be constructive even if industry analysts are excessively bullish.
We caution investors that broad US equity market returns are not likely to greatly exceed potential fixed income returns for the next year. To achieve higher equity returns, investors will need to be selective. As discussed in last week’s bulletin, small and medium sized growth companies (SMID) are an area of particular interest (see Figure 7 in PDF below). US SMID growth shares have grown EPS by 11% per year in the last five years, more than the 9% posted by large cap growth shares. They also don’t have the high leverage risks of SMID banks and real estate firms.
Yet they trade at a 30% valuation discount to large cap growth shares.
Q4: Could a Government Shutdown Crush Markets in November?
A: Given the House’s difficulty in securing a Speaker, the odds of a US government shutdown in a few weeks have risen. Rep Steve Scalise was nominated for the gavel with a 113-99 closed door vote but withdrew after it became clear that he could not secure the necessary 217 votes in the full House to take the speakership. With just a slim 221-212 majority in the chamber, Republicans cannot afford many stray votes in a party line election.
Without a Speaker, the House is essentially unable to function, so the pressure is mounting. Legislative action is needed to fund the government or a shutdown on November 17th will occur. US lawmakers appear likely to want to show support for Israel. And the White House is expected to request aid for Ukraine, Israel and to replenish the US weapons stockpile.
There have been 20 shutdowns in recent decades that have lasted 2-35 days before upsetting voters enough to force a compromise. From a financial and economic perspective, we view a possible November shutdown as far less consequential than the debt ceiling showdown that led to June’s Fiscal Responsibility Act (FRA). A partial shutdown could temporarily close non-essential services but should only have a small impact on the economy. However, the impact of a sustained shutdown on the 2024 elections is a wild card. On average, the S&P 500 returned 0.1% during the shutdowns since 1976 with a range of -4.4% to 8.0%
Q5: Is China Going to Take Action to Address its Anemic Economy?
A: We are seeing signs that Chinese authorities will take more material steps to bolster its economy. Economic sentiment has remained negative due to the ongoing real estate crisis and a lack of commitment to address the issue wholistically.
The focus of the Chinese actions is likely to be on infrastructure. The method of funding appears to be a bond issuance. A central government bond could provide a clear sign of the government’s intent to inject material economic support. This would require the government to increase its deficit target at mid-year, something that has only occurred before during the Asian and Global financial crises of 1998 and 2008, respectively.
In addition, Central Huijin, the sovereign wealth fund has taken larger stakes in China’s major four banks, a practice reserved for moments when strong policies are required to reset markets. Such interventions had produced positive returns in the past.
Moreover, the government had been in consultation with industry experts on a much larger stabilization fund. The securities regulator has had multiple consultation sessions with industry participants in recent months. Many uncertainties remain as to the timing, size, and operation of this stabilization fund, but the Huijin purchases are likely just an initial step in efforts to shore up the equity market, with what is basically quantitative easing. Moreover, there had been progress in the US-China relationship. The recent visit of the US Congressional delegation may signal potential indirect easing in US trade policy, to be followed by multilateral defense dialogue at the Xiangshan Forum in late October and a potential meeting between the presidents at the APEC summit in November. While markets are aware of the higher frequency of contact, it is still not pricing in any potential concrete easing of trade policy.
This type of stimulus would take time to have impact and would likely raise growth in the second half of 2024. We already expect some modest improvement in Q3 growth due to prior, smaller stimulus measures. We have seen a pickup in industrial and consumer activity since August. Meanwhile seasonality favors equity performance in 4Q (see Figure 8 in PDF below).
With that said, we do not believe these measures are sufficient to return China to a sustained higher growth rate. The focus on infrastructure rather than providing a more favorable environment for consumer, education and technology companies to grow more rapidly also has limited long term benefits. It remains to be seen whether Chinese authorities can provide a more complete real estate solution and restore commitment to market-oriented reforms.