Iran Retaliates; Inflation misbehaves
Geopolitical: US equities tumbled on Friday night as news leaked out that Iran was planning a strike against Israel. Unfortunately the intel was accurate and on Saturday night, Iran launched a wave of missiles and drones toward Israel, as regional tensions continued to mount over the war in Gaza. President Biden condemned the attacks and spoke with Israeli Prime Minister Benjamin Netanyahu to reiterate the United States’ commitment to Israeli security. Iranian state media said the attack was in retaliation to an Israeli strike on an Iranian diplomatic compound in Syria on April 1.
Initial indications show that Israel’s highly regarded air defence systems have successfully withstood their most significant challenge to date, countering an intense onslaught from Iran. According to military spokesman Daniel Hagari, in a briefing, Israel and its allies including the UK managed to intercept the “vast majority” of the 200 drones and missiles launched by Iran, neutralizing most of them before they could enter Israeli airspace.
The fact that Iranian officials are calling the attack a success despite it causing only minimal damage indicates the aim was always more about sending a message of deterrence than inflicting harm. The common line out of Tehran on Sunday is that the operation was a proportionate response to the Damascus attack, and that Iran is prepared to hit back harder if pushed. It would appear that Iran designed its retaliation to cause maximum symbolism, but minimum damage. By itself, it shouldn’t lead to anything too catastrophic for equity markets, but if it triggers an Israeli counter-response, then we’re spiralling into somewhere very dangerous.
G-7 leaders have issued a joint declaration firmly condemning the launch of missiles and drones from Iran and reiterating full support for Israel’s security. They underscored the need to avoid further confrontation in order to defuse tensions in the wider region and called for an end to the crisis in Gaza through a ceasefire and the release of hostages held there by Hamas. As with all financial assets, the crucial move in the Oil price seems to now hinge on what Israel does next. Trading in Oil and equity futures resumes at 11 pm London time on Sunday night.
Now I can’t possibly second guess what is about to happen short, medium or long term. I hope it blows over and some sort of compromise can be reached, but what I can say is that the ‘potential of a full on conflict’ had not been priced in to risk assets, as at the very least it would undoubtedly cause another surge in the Oil price. That would mean we could kiss goodbye to the hope of interest rate cuts any time soon as inflation would surely spike higher. The potential alone may well mean equities are on for a difficult ride over the next few weeks, but it could once more prove to be another storm in a teacup. The VIX Index is pointing to trouble.
US Inflation
Putting aside the geopolitical issues, data on inflation last week hasn’t increased the prospect of rate cuts by the Fed anytime soon. The so-called core consumer price index, which excludes food and energy costs, increased 0.4% from February, according to government data out Wednesday. The year-over-year rate was unchanged at 3.8%, defying expectations for a downtick. Further interrogation of the data revealed that the ‘super core’ measure is now trending up as services inflation appears to be escalating.
The US equity market sold off on the news and bond yields headed higher as you would expect, but we did then get some good news on Thursday as Producer Price Inflation came in lower than expected. That calmed things and we did see a sharp move higher from the Nasdaq that day, as investors who are still of a bullish disposition came wading back in to the market buying Big tech in particular. Notably bond investors didn’t buy in to the optimism as yields continued on their upward trend with the US 10 year yield rising above 4.5%.
As I have been saying for some time, if this equity market is going to hold at these levels and make further progress, the emphasis of the market has to move away from rate cut expectations to the more traditional metrics of economic growth powering corporate earnings. Right on cue, we have begun the earnings season for the US and much now depends on the numbers. First up on Friday we get the Big Banks reporting and investors didn’t like what they saw. Despite JP Morgan, Citigroup and Wells Fargo all beating Wall Street expectations when they reported earnings Friday morning it was the challenging outlook that investors chose to focus on. All the management emphasised the uncertainty facing their operations stemming from macroeconomic, geopolitical, structural, and regulatory challenges with JPM cautiously reporting that Net Interest Income going forward was unlikely to rise as hoped for.
On another day, these results – all strong beats – could have been taken well, but on the back of events in the ME and the rising inflation backdrop, investors were in the mood to see the glass as half empty. I think I detect in the forward guidance of management a desire to under promise and then potentially over deliver going forward, so I don’t think we should read too much in to the share price declines as the big banks look to be in rude health to me. However, what it does tell us is that the bar for earnings this quarter has been set very high indeed and that any companies that either fail to meet expectations or deliver a rosy outlook are likely to see their share prices fall.
ECB (13th Federal Reserve District) likely to move first on rates ..
The European Central Bank has often unfairly been referred to as the 13th District, with the implication being that is under the gravitational pull of the US and it will merely follow the policy decisions set down by the Federal Reserve. However, when we heard from Lagarde last week she was at pains to suggest that is not the case, ‘we are data dependent — we are not Fed dependent’. That is actually great to hear as I was getting a bit worried that the ECB and in turn the BOE would not perhaps have the stomach to part company with US policy and go it alone on the rate cuts that both economic regions surely need.
Whilst services inflation is still proving a little sticky on both sides of the Atlantic, albeit lower in the Euro area, there is a very marked difference in the direction of economic trajectory, as the PMI differentials highlight quite clearly. US Manufacturing is recovering and is now on an upward trajectory, European manufacturing is slipping. The Eurozone needs rate cuts, the US does not.
The reason why it is not that straightforward comes down to currencies. If the Eurozone moves ahead of the US, then the new interest rate differential could cause the Dollar to strengthen versus the Euro and that has secondary inflationary impacts. But it would seem that now looks like being the lesser of two evils and I think barring a potential oil price shock, we will se a rate cut in June and you can already see the currency markets begin to factor that in as the Euro has fallen from 1.10 to 1.06 against the USD since the beginning of the year.
UK
More good news here as in February, the UK economy experienced growth for the second consecutive month, reinforcing indications that the brief, mild recession at the end of last year has concluded and a recovery is taking shape. The Office for National Statistics reported a 0.1% increase in gross domestic product from January, aligning with economists’ predictions. Additionally, January’s growth was revised upward to 0.3% from an initial 0.2%. The numbers could have been even better but for the weather, as the amount of rain we had undoubtedly curtailed the building sector and retail sales.
Now this level of growth is not so scary as to reignite inflationary pressures in my humble opinion and should not undermine the Bank of England pressing ahead with a rate cut this quarter, especially if Europe is going to take the risk. Here too this prospect has already begun to show up in the currency markets with the Pound falling to a year low of 1.245 against the Greenback. For more than a fleeting moment I thought the FTSE 100 was going to break through meaningfully above the 8,000 level and hold it in to close but the sell off in the US dragged us down.
Still there definitely seems to be some positive momentum behind the UK stock market now – Oil and Mining stocks have been charging – and I see very many reasons to be much more upbeat on our market than at any time since Brexit.
Lets hope for common sense to prevail in the Middle East …..