In a short week due to Easter, here in London, events in the Middle East continue to dominate the performance of financial markets.
As at the beginning of last week, bonds and equities saw a strong rally following a sudden shift in sentiment, based on the idea that the Trump administration was close to exiting the conflict between the United States and Iran.
However, in his latest speech, Trump provided no updates in terms of progress towards an agreement. On one hand, the rhetoric from the US President (albeit rather inconsistent) suggests a relatively quick end to US involvement in the conflict; on the other hand, on the ground the situation appears different, as the United States continues to strengthen its military capabilities in the region.
With Iran continuing to deny progress in talks and contradict Trump’s comments, one could argue that little has changed and investors remain disoriented in a context characterized by conflicting messages and signals. It remains difficult to predict which direction the conflict will take in the short term, but two points appear clear.
Firstly, the US administration would like a rapid conclusion to the conflict and the negative fallout it is having on the global economy, while managing to declare a unilateral victory. Secondly, the Strait of Hormuz remains largely closed and missiles and drones continue to fly over the region, damaging oil and gas infrastructure.
In this context, even a quick way out, at this stage, with oil flows still compromised, would continue to have lasting and uncertain economic and geopolitical repercussions.
It is possible that the most likely outcome is some sort of compromise that is not entirely satisfactory. The United States could exit the conflict declaring a victory in terms of weakening Iran’s military and nuclear capabilities, but leaving the situation in the Strait of Hormuz unresolved and requiring complex negotiations between Asian and European countries and Iran to restore the flow of ships.
However, as was the case with the reversal of the Liberation Day policy last April, investors still seem eager to buy on dips. A rapid reversal, however, will be much harder to achieve compared to previous geopolitical episodes, if reality is characterized by high oil and gas prices and supply chain disruptions. This suggests there is ample room for this complacency to be challenged as the new reality emerges.
In core rate markets, it was interesting to observe during the week how the market seems to be overcoming the peak of panic regarding the impact that higher inflation could have on central bank action.
Short-term maturities have stabilized and a possible shift of focus from inflation and the extent of potential rate hikes towards risks of weakening demand, impact on consumption, growth and the labor market, and consequently the hypothesis of rate cuts, is emerging. The result is a transition from a bear flattening of the curves to a bull steepening.
In Japan, as in other economies, the rise in oil will be negative both for inflation and growth. This week’s data were mixed, with Tokyo’s CPI remaining well below 2%, while the Tankan survey remained solid on the price front. Furthermore, with the yen near 160 against the US dollar, markets are currently pricing a 50% probability of a BoJ rate hike by the end of the month.
We know that Prime Minister Takaichi is very focused on supporting growth and, from this perspective, it can be argued that she might want to counter the BoJ’s rate normalization. However, a more accommodative BoJ could fuel fears of a more prolonged overshoot of the inflation target, putting pressure on the curve. We remain positive that the 10/30 JGB curve could further flatten in the medium term.
Looking Ahead
What we know is that the macroeconomic fog should start to clear relatively soon, once the direction of events becomes clearer. At this stage, we are positioned relatively close to neutrality in terms of directional beta and well placed to adopt a more decisive stance when the situation stabilizes.
From a fundamental perspective, higher oil and gas prices are already having a global economic impact, with policymakers revising inflation forecasts upward and growth forecasts downward in light of ongoing disruptions.
In a context characterized by a flow of contradictory messages, distinguishing signal from noise is not as simple as one might think at this moment. In this scenario, it is understandable that markets seem to be walking a tightrope.
Consequently, “walking on eggshells” appears to be the most appropriate attitude for investors in the short term. Speaking of eggs, we wish you a happy (and hopefully peaceful) Easter.
