Equity Markets Exhibiting Resilience
Risk assets are bouncing back today following Friday’s slide, as dip-buyers stepped in following a weekend of limited Israel-Iran escalation and comments from Iran that they would like to de-escalate the situation. I’m not a geopolitical expert, and my knowledge on the nuances of what’s playing out between Israel and Iran is about an inch deep (if that) and a mile wide – so look elsewhere for color on that subject area. I’ll stick to markets and potential implications from these events and other variables affecting markets.
However, it's worth dissecting Friday’s market action as a template for how investors should think about navigating major geopolitical events. The short-term winners were defense contractors (Lockheed Martin and Northrop Grumman each gained nearly 4% on the day), and energy stocks rallied nearly 2% on the day (six straight weeks of gains) as is typically the case whenever there is a flareup in the Middle East. Additionally, you saw the usual rally in the defensive areas of the equity market with Consumer Staples, Utilities, and Healthcare showing relative strength. What got hit the hardest on Friday was Consumer Discretionary – areas impacted by a squeeze on consumers' pocketbooks with the rise in oil prices, with Airlines getting tagged the worst (higher fuel costs and potentially slower travel demand).
Something to keep in mind regarding the oil market is that spikes triggered by geopolitical flare-ups tend to be brief and inevitably reverse as the market eventually reverts to variables that are driving long-term fundamentals. Take the Russian invasion of Ukraine back in February 2022 for example, where WTI spiked to $120/bbl into June 2022, but faded back to around $70/bbl by December 2022. Similar story in April 2024 at the first iteration of skirmish between Israel and Iran, which pushed oil up to $87/bbl only to see it trading back below $70/bbl by mid-September. Ergo, fading the geopolitical spike has been the correct call in recent times, just like ‘buying the dip’ in the broad market on these fleeting downside spasms.
The point is that the dominant driver of oil prices will prevail over displacements driven by unsustainable disruptions (shutting down the Straits of Hormuz is a different story). The dominant driver today is that the world is awash with oil at the moment, and the Saudis have a ton of reserves that they could release into the market at a moment’s notice. Furthermore, this near-term oil glut is buttressing a soft demand environment. However, I will say that I like the setup for oil producers and the energy sector on an intermediate to long-term basis. We are talking about a sector that is down to a 3% weighting in the S&P 500, with investor sentiment and positioning at bombed-out levels. Not to mention steady declines in the U.S. rig count as U.S. shale oil production looks to be plateauing. Any investor with a time horizon that extends beyond their nose should take a look at this sector, where cash flow yields and valuations are compelling.
As for the bond market, Treasuries didn’t get much of a flight to safety bid (neither did the dollar) in the risk-off move on Friday. Although the yield on the 10-year T-note did close the week down 9 basis points to 4.41% on some decent treasury auctions, surprisingly tame inflation data (both CPI and PPI came in below expectations), and weakening trends in both initial and continuing jobless claims. The bond market has now dialed back rate cut expectations to just two cuts, with the first one coming in September. This is one area where I agree with President Trump, in that I think the Fed needs to shift its stance from ‘wait and see’ towards a loosening bias. Not that I believe the name-calling and badgering of the Fed Chair is the right approach, or that a 100 basis point immediate rate cut is appropriate, but I do think markets are underpricing the number of rate cuts we’ll end up getting over the next twelve months. I say this while expecting inflation prints to inflect modestly higher over the next several months.
One area that will start to affect the inflation data and pinch consumer wallets over the next several months is the increase in American power bills. The price of natural gas is up 23% since April 21st, and utility companies are passing along to customers the costs of investing billions of dollars into an aging and worn electrical grid. In several states, demand from data centers is putting pressure on the grid and pushing prices higher as electricity supplies tighten (electricity prices across the country have increased nearly +4% in the past year, more than double the pace of grocery price inflation). Add to this summertime weather conditions, where the EIA expects the average U.S. residential electric bill to be about +4% higher this summer compared to last – mostly as a result of a jump in prices of natural gas.
This is one of many reasons why we’ve warmed to the utility sector in general and a couple of individual companies with unique niches in this area. Not to mention the unfolding of a Nuclear Renaissance, one of our favorite commodity/power themes going back eight years. Uranium, which is the raw commodity that gets processed and fabricated into pellets that go into the fuel rods that power nuclear reactors, got another shot in the arm last week with the announcement of a private placement by Sprott to raise $200 million to buy uranium for its physical uranium trust. This is a big development at an interesting time for this small segment of the energy industry given that supply is tight and inventories are lean. How the price of uranium reacts over the next couple of weeks should provide investors in this industry with some much-needed transparency on just how tight the spot uranium market is at the moment.
As for another commodity I’ve spilled a lot of ink on over the years, gold rallied more than 3% last week to just over $3,400/oz. Gold is now up 30% on the year with gold miners up an even more impressive +58%. It really is impressive to look back at the climb in gold prices over the past several decades: eclipsing $1,000/oz in 2008, $2,000/oz in 2020, and now pushing above $3,000/oz in 2025. Look, there are a lot of explanations that tie into the “why” gold has moved higher over the years, and I don’t care to get into all of them in this missive, but one of the more recent developments is the increased purchases by sovereign governments and global central banks.
Recent data shows gold surpassing the euro to become the world’s second-largest reserve asset (U.S. dollar is the largest) among global central banks. Central bank net purchases of gold started to increase in the aftermath of the GFC (see chart below from the FT). They took another leg higher (more than +1,000 tons annually) in the past three years when the U.S. and other allies froze Russian assets following its invasion of Ukraine. I’m not advocating investors go out and back up the truck at this moment given the move we’ve seen over the last 18 months, but I’ve long recommended that all investors should have at least some exposure to the yellow metal – a lot of investors have none, and most investors have too little exposure.
The increase in power demand, broadening out of fiscal stimulus around the globe, onshoring/mercantilist policy initiatives, and continued debasement of fiat currency all argues for investors to favor real assets over financial assets for the foreseeable future. That includes a tilt towards high quality stocks, well located real estate, commodities, and precious metals over cash and fixed income. Michael Harnett said it well in his “Flow Show” report released last Friday:
“The Biggest Picture: AI eats commodities, Emerging Markets make commodities, US$ in bear, EM stocks at 50-year lows vs US (Chart 2), long EM…easy allocation decision.”
Let me end with some closing thoughts on the equity market. Outside of an exogenous event, I don’t expect many surprises from the equity market over the next several weeks. Frankly, I’m of the view that the option markets and vol-control funds are set up to keep the S&P 500 pinned in this 5,900 – 6,000 range into the end of June. Sure, we can have a blip above or below this range. Still, with most of the major economic data already released and the Q2 earnings reporting season more than a month away, I just don’t see much of a catalyst that unpins the S&P 500 from the positive gamma environment option dealers are managing. Not to mention the volatility index settling down into the high-teens, which will cause vol-control funds to be net buyers of stocks – more aggressively on down-tapes and less aggressively on up-tapes, but buyers nonetheless. So, while I think July – September could and will be more interesting and volatile, I think investors should embrace and appreciate the calm that exists in the present.
As for the week ahead, the G7 summit will be sure to garner investors' attention with the focus on positive or negative developments on the trade front. Key American allies will be present at the summit (Japan, EU, and Canada) where a united front or even some further push back by foreign leaders on Trump’s “America First” policy could cause Trump to re-escalate the tariff war. Additionally, the Fed will conclude its June FOMC meeting on Wednesday, where they will release their latest Summary of Economic Projections (SEP). Powell has been singing the same tune for almost six months now in suggesting that economic growth is solid, but the labor market is cooling. At some point, if the labor market continues to cool (which it is), Powell is going to be forced to shift from holding firm on the inflation front in favor of supporting the labor market. A lack of acknowledgement by the FOMC on the improvement in inflation towards the Fed’s target will likely provoke President Trump to move more quickly towards naming a replacement for Powell and/or a Fed chair in waiting, thereby making Powell a lame duck and forcing investors to pay more attention to his replacement than to Powell himself.
The articles and opinions in "Capital Market Musings and Commentary" are for general information only, and not intended to provide specific investment advice. Performance, dividends and other figures have been obtained from sources believed reliable but have not been audited and cannot be guaranteed. Past performance does not ensure future results. Investing inherently contains risk including loss of principle. Advisory services offered through Casilio Leitch Investments, an SEC registered investment advisor.
Copyright © 2023 Casilio Leitch Investments. All Rights Reserved.