Economic Statecraft On Full Display
The center of the universe for markets right now is oil prices – everything else is a derivative of the squeeze on oil due to the lack of transit through the Strait of Hormuz. The big news last week was obviously the +36% surge in WTI crude towards $90 per barrel, the sharpest spike since futures began trading in 1983 (and back above $100 per barrel this morning). So far, if this run-up is not reversed soon (3-4 weeks tops), we would be talking about a significant hit to global growth figures and a dramatic increase in recessionary risks. It’s not just about oil and natural gas, but shipping, fertilizer, and food costs.
I’m not there yet, and neither is the market, but understand that a lot more pain awaits risk assets if we get there. Beyond the pinch from higher oil prices, markets are being pressured by the impact of a meaningful tightening in financial conditions via a firmer U.S. dollar, higher real rates, the pullback in the stock market, and the recent widening in credit spreads.
Another market move (beyond oil prices) that grabbed my attention last week was how the Emerging Market (EM) complex got exposed in terms of its very high reliance on the Strait of Hormuz for its energy imports – which is also key to the region’s tech prowess. The EM stock market sagged -7% last week, far worse than the -2% pullback in the S&P 500, in its worst showing since February 2018 (excluding the pandemic). This led me to make a subtle adjustment to our EM exposure – reallocating some of our overweight East Asia exposure to Latin America (East Asia is highly dependent on energy imports, while Latin America is a large energy producer). I still like EM and foreign equity exposure in portfolios on an intermediate term timeline, and I do expect they will rally back hard if/when we get past this global oil chokepoint. But we were underexposed to Latin America and didn’t want to pass up this opportunity to fix that.
It wasn’t just EM that underperformed last week, as every major non-US geography underperformed the S&P 500, which fell -2.0%: Europe (-6.4 pct), Japan (-8.2 pct), and Emerging Markets (-8.4 pct). Going into March, the S&P 500 was lagging the ROW (Rest of World) by 10%, and after last week, the gap narrowed to just under 5%. The Nasdaq was also a relative outperformer (-1.2% vs. the S&P 500 -2.0%) as the narrative of AI displacing software went on a sabbatical with the iShares Expanded Tech Software Sector ETF (IGV) rallying nearly +8.0% in a down tape (MSFT was up +4.1% on the week).
Two additional challenges for investors last week were that bonds did not provide any diversification benefits relative to stocks (unless you take solace in the fact that they fell less). The second was the renewed confidence in the dollar as a safe-haven asset, which just goes to show that the U.S. exceptionalism trade (global capital flows flocking to deep U.S. markets) is going to be tough to break. In a nutshell, the places to hide have been extremely limited, outside of cash (in U.S. dollars), Energy, Defense, Utilities, and base metals. Safe havens may be outperforming in a relative sense, but even they have not offered any refuge in absolute terms, whether it be gold (first weekly loss in over a month), Treasuries, Health Care, or even Consumer Staples.
Another area that has been ascending the worry list is what is playing out in the private credit space. Last week, BlackRock, considered one of the premier players in the space, announced that it was limiting withdrawals (for the first time ever) on its flagship private credit fund. Investors might be jumping to conclusions, but shades of Bear Stearns in the summer of 2007, which served as a canary in the coalmine, are coming to mind. Nevertheless, it was troubling to watch the share price of the world’s largest asset manager sink -7.7% to a ten-month low and off nearly -21% from the highs. As for the S&P 500 Financials sector, a consensus favorite coming into the year on reflation and deregulation excitement has officially ticked into correction territory, having slid -12% from its early-January peak.
As far as the Treasury market is concerned, one reason why it has not managed to rally in the face of all the uncertainty is not just the oil-induced inflation shock, but also the swaps market pricing out (at least partially) Fed easing this year. Odds of a rate cut through the June meeting stand at 41% — barely lower than the 49% probability before the weak payroll report was released. It was just a month ago that market-based odds were 75% for a summertime easing.
Look, it's hard to take a stand on the equity market without exercising some game theory on those calling the shots in the war between the U.S./Israel/Iran and how it impacts oil prices. Even if Trump wants to find an off-ramp, it’s unclear if there is an Iranian government to negotiate with, or if they have any interest in de-escalation following the destruction inflicted upon them. Until there is some clarity on this front, I suspect we’ll continue to see a risk premium built into oil prices, which amplifies market uncertainty.
All that said, I’m as in the dark as many of you when it comes to strategy, tactics, objectives, mission plans…we’re all interpreting media reports, intelligence briefings, and real-time events as they come to light. But none of us are in the room at CENTCOM where these discussions are occurring, so we are all on the wrong side of an information asymmetry that, at best, gives us educated guesses and nothing more. However, a couple of things I’m seeing that cause me to lean a bit more constructively as it pertains to markets are that there have been far fewer Iranian missile and drone attacks in recent days (this is a moderation in the threat level), and the President has vowed that the U.S. Navy will soon be escorting oil tankers. Assuming this remains the case, it makes sense to expect oil prices to inevitably come down (from what peak is anyone’s guess), with the caveat that shipping bottlenecks ease. Just remember this: when Russia invaded Ukraine four years ago, WTI jumped from around $70 per barrel to almost $125 per barrel, and within three months they were back down to $90. Within twelve months they we were right back down to $77 per barrel, despite all the forecasts (as is the case today) of oil surging to $150 per barrel or higher – which never did happen.
In discussions with colleagues, other industry professionals, and clients, a typical conversation topic is why? Why is the administration doing this? How does this benefit the U.S. and at what cost? Frankly, I don’t know the answer, but my contribution to the conversation is often rooted in what Michael Every of Rabobank calls the U.S. pivoting toward ‘economic statecraft.’ Keep in mind this isn’t me making a judgment call – right/wrong, good/bad, success/failure…but rather how I’m observing, interpreting, and analyzing the interaction of the global economic setup and policymakers' actions. With that in mind, I am of the view that we are witnessing a structural fracture in the era of seamless globalization. The rise of China, devastation in U.S. industrial capacity, supply chain risks, affordability crisis, unrelenting rise in Federal debt, rise of MAGA on the right and progressives on the left…and the list goes on, can all be used today as pretexts to threats against national security (in some fashion).
For decades, the global system prioritized open markets, economic rationalism, and frictionless trade. In my opinion, that consensus is now being overridden by the return of hard power, national security imperatives, and sovereign self-interest. Countries around the globe and boards of directors are realizing that economic efficiency cannot supersede baseline security – Covid accentuated this risk. All of which amounts to free, frictionless trade coming under threat from "economic statecraft." What started under Trump’s first term was continued under the Biden administration and taken to a new level in Trump 2.0 – tariffs, export controls, and sanctions are being used to forcibly fracture the global economy into distinct, regionalized blocs.
Investors should go back and reread the National Security Strategy report released last November, where it didn’t mince words in that this administration's objective is to consolidate its sphere of influence, where the U.S. uses its economic weight to lock down raw materials in the Western Hemisphere and dictate trade terms with allies in exchange for security guarantees. We are witnessing a shift from a world optimized for efficiency and margin expansion to a world optimized for resilience and survival. That’s a difficult transition for investors to navigate, let alone for policy makers to implement.
For all those who criticize President Trump over what he is doing in Iran, it is all part of his grand plan to reorder the world, definitively reclaim U.S. influence in the Western Hemisphere (think of why he craves Greenland and muses about Canada as the 51st state), and mitigate the menace from America’s adversaries. The question is asked — why is Trump targeting Cuba? Answer — Cuba is an Iranian and Russian satellite residing just 100 miles off the coast of Florida. The friend of your enemy is your enemy. Think of what the real story was regarding Venezuela. It wasn’t about drugs. It was about Maduro selling its oil to China – which had emerged as a primary buyer last year, using “shadow fleet” tankers to bypass the U.S. sanctions (purchasing nearly 400,000 barrels per day). And we know that since last June, China had been busy helping Iran rearm. Now we hear that Putin is sharing information with the Iranian military on the locations of U.S. military assets in the Middle East.
Again, all part of the “Donroe Doctrine.” But make no mistake, this is a world war, and both China and Russia are involved behind the scenes, all in an effort to destabilize the West. Any one of us can question the tactics, second-guess the motivations, and pass judgment on the results – that is our right as citizens of a democratic society (even if it's messy at times), but I think it's unfair or lazy to conclude there is no long-term strategy. We may not like it, but that’s a different point. Call all of this a pre-emptive strike against the forces of evil. Let’s hope that these upcoming meetings with Xi Jinping result in a combination of détente and deterrence.
The fact that President Trump has four meetings coming up with Xi Jinping, the first coming on March 31st, is definitely good news because the question for China is whether it intends to be a problem or part of the solution to this crisis in the Middle East. Not to mention that Xi is watching very closely, because if the United States (and Israel) don’t finish the job with Iran (and yes, that includes the regime), one can envisage a situation where the Chinese President makes a move of his own in Taiwan (think of another blockade, this time the Taiwan Strait).
Thank you for humoring my meandering thoughts on the geopolitical file, and keep in mind they are just that, thoughts. I mean no offense, and openly welcome anyone interested in telling me I lost my marbles, albeit in a respectful and engaging manner. Let’s finish off with some thoughts on markets and what I’m monitoring as indications that things are improving or deteriorating.
Coming into the morning with S&P 500 futures down as much as 2.5%, things were getting pretty grim. Markets across the board were on the cusp of becoming a tad unhinged, where emotion was starting to overtake rational judgment. I know, I say that with the S&P 500 barely down more than 5% from its all-time high, but I’d argue that carnage beneath the surface has been much more informative than the resilience in the S&P 500 leads on.
One indicator I’m watching closely is the VIX index as it nears levels that have typically marked short-term bottoms in stock market selloffs. The VIX got as high as 35 this morning, which is two standard deviations above its long-run mean. The forward returns for equities after a close above 35 in the VIX are positive 66% of the time after one week and 74% of the time after one month. Amidst a true crisis, it's not until the VIX gets north of 40 that we experience a capitulative / washed-out buying opportunity. We haven’t gotten there yet, and I’d prefer we didn’t (things will be pretty ugly at that point), but we’re in the ballpark where investors should be starting to think about shifting their mindset from defense to offense.
Another thing we need to see is a calming in the price of oil. When oil prices are the most important quote on an investor’s screen, you know something has gone wrong, and only a sustainable move lower in the cost of this critical global commodity can put things right again. On this front, one variable that cannot get any worse is transit through the Strait of Hormuz – as there currently is none (or very limited). For all intents and purposes, there are roughly 10 million barrels a day of global oil supply that isn’t finding its way onto the market. Any thawing on this front will be a very constructive development for markets. You know President Trump is paying close attention to this, and understands what's at stake with midterms around the corner.
Michael Hartnett, Chief Strategist at BofA, is credited with a market adage I find applicable during times of turmoil and market stress:
“Markets stop panicking when policymakers start panicking.”
Well, I can help but think about that when I see the following headlines hitting the tape:
France Finance Minister Lescure: We Are Ready To Take Action To Stabilize Markets - Ready To Use Strategic Oil Reserve To Stabilize Market
G7 Finance Ministers Ready To Take All Measures - G7 ‘Not There Yet’ On Releasing Oil Stockpiles
Interest rates and the dollar are always important to watch during risk-off environments. Thus far, the moves in each haven’t been damaging – both have moved higher, but neither has broken out of the range they’ve traded in over the past six months. What would worry me is if oil prices were to stay elevated (a stagflationary risk), but Treasury yields started falling. That would be a signal to me that the bond market was starting to price in a recession, in which the growth hit from higher gas prices was a bigger concern than inflation risks.
Big picture, I don’t see enough damage yet to shift from the constructive stance we’ve had. Earnings continue to look solid (very little in the way of downward revisions) and inflationary pressures, outside of this spike in oil prices, look like they will continue to be supportive of the Fed pivoting back to a dovish bias later this year. I will say that the jobs report last week was concerning. A decline of -92k jobs in February is not a good number, and we continue to get negative revisions where every single month dating back to January 2025 has been revised lower from the initial estimate. David Rosenberg did the math for us on this front with this graphic in his note this morning (that’s 1.1 million fewer jobs than the initial estimate):
Why the Fed refuses to acknowledge the weakness in the labor market remains a head-scratcher to me. Analysis is never about just one thing, but looking at these labor market numbers suggests that monetary policy is too tight. This is also why I think the Fed will be cutting interest rates later this year. I just hope that by that time we haven’t shifted to an environment where we're more concerned about why the Fed is cutting (because things are so bad) than about the fact that the Fed is cutting.
I’ll leave you with this. The current situation is extremely fluid with markets on thin ice. This morning, things could have broken down in a bad way, and it is no surprise to me to see trial balloons being floated by officials from this administration and policymakers around the globe that they are ready to take steps to stop things from deteriorating further. So, keep some powder dry. Keep your wits about you, and please do not panic. These event-driven oil price spikes never last, and merely sow the seeds of their own demise through the demand destruction in their wake. The ‘fog of war’ is another animal altogether, where none of us has any control over how it plays out. The best we can do is read and react.
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