I’m Closing The Strait, No, I’m Closing The Strait
Highlights:
The Chokepoint Dilemma: Historical precedents indicate that control of critical maritime chokepoints is rarely achieved through naval superiority or closure alone; rather, these crises are typically resolved through negotiated settlements. In the current standoff, watch for the influence of major energy-importing nations – specifically China, India, Japan, and South Korea – to play a factor that determines how/when this conflict gets resolved.
Macro Disconnect and Passive Flows: A profound divergence exists between a "feeble" U.S. macro environment—evidenced by consumer sentiment hitting its lowest level since 1952—and record-high corporate profit margins. Equities care more about the latter, so as long as they continue to grow, its difficult to get too negative on stocks.
Strategic Themes and Global Shifts: As the world moves past "peak globalization" toward policy centered on national security and energy independence, market leadership is concentrating in AI-related physical infrastructure and power resilience. What was leadership prior to the Iran conflict is reasserting itself as leadership since the ceasefire (AI, semiconductors, energy, foreign equities, commodities…) while areas that were weak continue to remain so (software, healthcare, IT services…AI disruption theme).
Full Commentary
Events over the weekend have proven we aren’t completely out of the woods yet when it comes to the Iran/U.S./Israel war, with President Trump announcing that he intends to implement a full naval blockade on the entire Strait of Hormuz. What we have learned over the weekend is that there appears to be an unbridgeable gap between the two sides, in particular over nuclear capabilities and control of the Hormuz Strait. In an effort to oversimplify the matter, this all comes down to who ultimately has control of the Strait of Hormuz; that is, who will be perceived as the short-term victor, and everything else is some semblance of a consolation prize.
However, this is where the complexity lies: for Iran, control of the Strait is existential and a question of survival. With a significant portion of their military capacity destroyed, they have nothing left to lose and stand ready to withstand pain for longer. As for the U.S., it’s a costly and complicated equation – high gas prices, mid-term elections, and the idea of economic pain for allies make it very challenging to prolong the conflict.
As the saying goes, in a war, one’s ability to withstand pain is even more important than one’s ability to inflict pain. From my perspective, it can be argued that Tehran, not needing to worry about its population or midterm elections, is winning this war in a strategic sense, even if it lost in a military sense. Don’t get me wrong, from what I read Iran has incurred a significant amount of damage considering that it has lost control over its air-defense system, has no more navy, its nuclear capacity are degraded (at least for a few years), and much (but not nearly all) of its weapons capacity has been destroyed after 13,000 U.S. strikes over these past five weeks. Not to mention the damage to railway lines, bridges, steel plants, petrochemical facilities, manufacturing plants, airports, and parts of the power grid are estimated to now be as high as $1 trillion. Nevertheless, the outcome of this fight for Iran is now viewed as existential to its geopolitical status on both the global stage and within the GCC. This sense of pride and military capability helps to explain how Iran has lasted this long, with its cheap artillery costing it 1/100th of the price of America’s sophisticated and expensive missiles.
History has innumerable cases in which a perceived lesser power challenges the leading world power over the control of a critical trade route (e.g., Suez Canal crisis when Great Britain's control of the Suez Canal was challenged by Egypt). However, the archives clearly demonstrate that it's typically not the party that closed or seized a major maritime chokepoint in the modern era that’s achieved its strategic objectives through closure alone. Case in point: Britain’s experience with the Suez Canal in 1956, Japan’s experience with the Malacca Strait in World War II, Iran’s experience in 1980s Tanker War & The Gallipoli Campaign’s experience to seize the Dardanelles Strait in World War I.
The pattern that emerges is this: chokepoint crises are not won by the state that controls the geography or the state with the strongest navy. They are won by the party that best manages the escalation dynamics and secures support – or at least the acquiescence – of the great powers whose economies depend on the waterway. In 1956, that was the US. Today, the critical audience is China, India, Japan & South Korea – the nations that import most of the Hormuz crude. Their stance might determine whether Iran’s closure produces leverage or isolation, and whether the U.S. blockade is sustained or becomes untenable.
Iran has proved something important – closure works as a weapon of denial and modern asymmetric technology has made it cheaper than ever. But disruption is not leverage unless it can be converted into a negotiated outcome. Iran’s challenge is that it has burned the off-ramps. The U.S. administration does not seem interested in the kind of face-saving diplomatic architecture that resolved the Suez crisis. However, the U.S. challenge is also equally stark – we can have full naval superiority but may not be able to clear a mined strait quickly enough to prevent a supply-shock driven economic crisis.
Stated simply, outside the U.S. unleashing its entire military capabilities and turning Iran into a parking lot, the resolution of this conflict is going to come down to forces outside of direct control by Iran, Israel, and the U.S. Each side has too much to lose without being able to claim victory which is likely why outside influence will play an important role. Every historical precedent says that military force alone will not produce this outcome. The question is how much damage the world absorbs before all parties arrive at the negotiating table, which history says is the only destination.
That’s my two cents on the geopolitical gymnastics taking shape at the moment, which remain fluid. On to markets, where equities rode the ceasefire announcement to a strong week of gains with the Dow jumping +3%, the S&P 500 ripping +3.56%, the small-cap Russell 2000 surging +4%, and the Nasdaq ramping by +4.45%. Gains outside the U.S. were even stronger with the All-Cap World Ex. U.S. index up +4.9%, Latin America +6.1%, Emerging Markets (IEMG) +6.7%, and South Korea launching higher by +12.9%. Gold managed a modest rally of 1.8% (up 10% ytd) while gold miners gained +5% (up 16% ytd). What we had last week was a setup ripe for a short-covering rally, with many investors positioned for things to get worse, not merely better on the margin. Bond yields were little changed with oil prices, while falling nearly 20% from their highs, still holding firm between the $90 – $100 per barrel level.
So what does all this mean for risk assets from here? At 6,825 on the S&P 500 I’m back in the camp where the risk/reward setup ain’t great. Yes, technical flows are very supportive near-term, but beyond that it’s hard to envisage real buying without a fully negotiated agreement in place. From its January 27th high to its March 30th low, the S&P 500 fell -9.1% and has since rallied +7.5%. Moreover, the S&P 500 closed at 6,878 on Friday February 27th (the day before the U.S. began bombing Iran) and is currently trading at 6,831, so virtually unchanged with the economic and fundamental backdrop more fragile and uncertain than six weeks ago. The U.S. economy is truly sucking wind here, with real GDP growth looking to come in at a +1.3% annual rate in Q1 after the just-revised +0.7% print for the last quarter. Real final sales this quarter are on track for just a +0.8% pace, which means negative when adjusted for the government reopening. There may well be green shoots in the headline-driven stock market, but that is not the case when it comes to the macro data.
It is abundantly clear, despite the Wall Street narrative, that the U.S. economy was struggling before the war began, and the series of shocks since have not abated. Energy costs remain super-elevated and mortgage rates remain near their multi-month highs. Fertilizer prices are still up +40% since late February, just in time for the spring planting season, and diesel prices are stuck near a punishingly high level of nearly $5.70 per gallon.
Which brings me to a final point on this abridged list of items fueling my skepticism, and this was the real bombshell in terms of last week’s data flow – that being the University of Michigan’s consumer sentiment index for April, which plunged to the lowest level since the series began in November 1952. Imagine that – a sentiment survey spanning nearly eight decades undercutting the lows of all the prior eleven recessions and all the various crises, yet equity markets couldn’t care less, which perfectly punctuates what is meant by the K-shaped economy.
Let this serve as another reminder for why the economy is not the stock market, and vice versa. Economic fundamentals look feeble, but corporate profits, which is what equity shareholders are buying, are at record highs.
So, yeah, I’m skeptical that we should be trading at the levels we’re at today, but what do I know. I’ve learned to listen and respect the market rather than tell it what it should or shouldn’t be doing. The structural dynamics from passive flows are one of the major factors explaining why markets fail to sell off materially when faced with potential cataclysmic consequences from disruptive events. More investors are in the passive ‘buy and hold forever’ camp than there are active investors pushing prices around on the fringes.
Until we see a material downturn in employment which alters the automated 401k flows into the broad equity market and/or a larger number of boomers are forced to liquidate holdings to fund RMDs (this is coming), the active management community doesn’t control enough capital in the markets to overpower the massive structural tailwinds of passive flows. As a result, we get these episodic periods of downside volatility that eventually run out of selling pressure from the systematic and discretionary trading community before the structural tailwinds of passive flows get markets back on course to matriculating higher. This doesn’t make the investment case for equities a free lunch, as a recession or meaningful disruption to the labor market causes these tailwinds to do an about face. We’re not there yet, but recent work by Mike Green (the pioneer of this thesis and who has been spot on with these structural dynamics) estimates its out there in the 2028 – 2030 time period.
Corporate profits growing and clipping new all-time highs (see chart above) is another important factor for equities acting as well as they are. Consensus estimates from Wall Street analysts have been busy of late boosting their full-year earnings forecasts despite the margin-crimping surge in energy costs (to +19% from +15% in late February), and for the Q1 reporting season about to begin, an expectation of a +14% YoY pace (this would be the sixth consecutive quarter of double-digit EPS growth, which would be the longest such streak in fifteen years).
By this Friday, fully 10% of the S&P 500 membership will have reported, with the Q1 earnings season kicking off as usual with financial releases from the major U.S. banks – Goldman Sachs reported this morning, JPMorgan tomorrow along with Wells Fargo and Citigroup. Other banks report later this week. The key will be guidance on the shape of the consumer and private credit impact. Aside from the banks, major company results this week include Netflix, Johnson & Johnson, and PepsiCo. The bar has been set very high – after all, these earnings estimates are close to triple the trend in nominal private sector demand growth. But should they deliver, it would support the S&P 500 trading at the current 20x P/E multiple on future 12-month earnings while likely providing some momentum for it to make new all-time highs.
I’ve been vocal in these missives since the war began that investors would be best served to take a balanced approach within their portfolios. Having some exposure to defensive assets that will preserve capital should things go pear shaped, but still maintaining some exposure to areas that will do well if things work out in a constructive manner. Let’s focus on the latter set of portfolio exposures for the moment. The price action in the last 6-8 weeks is instructive in that it encompasses moves to both the downside and upside, while providing some insight into the market’s favorite themes. This provides investors with an idea of themes and stocks you can buy on dips/continue to hold with a solid structural backing. Unsurprisingly much of the winning themes were AI related – optical networking, AI data centers, memory & storage, AI winners vs losers, etc – they are the best performing YTD, had relatively mild draw-downs during the war and had huge bounce-backs on the ceasefire agreement. It’s worth noting that while energy corrected a bit due to the ceasefire, it has done well through the year underscoring the bid for physical infrastructure just beyond the short-term with structural forces in play. The structurally challenged themes – software, IT services, AI at risk, etc saw increased shorting through the conflict and even more so upon the ceasefire being declared.
As I mentioned last week, the MAG7 group looks interesting having rerated over the past six months which has compressed Tech valuations from 40x to 20x. We are back at levels last seen before the AI boom began.
Another area that was leading the way prior to the start of the Iran conflict (and has ripped since the cease fire announcement) is international equities, and emerging markets in particular. A question I find myself pondering quite often of late is who are the biggest beneficiaries of this conflict? I think this will reinforce a transition that was already underway with countries continuing to walk back from globalization and an overreliance on a global supply chain that can no longer be trusted like it has been in the past. This isn’t an end to globalization, but rather another event that further cements that we’ve moved past peak globalization, where policy choices will center around national security, self-reliance, and energy independence.
China comes to mind as one of those countries that stand to be a major beneficiary of this global conflict. There are several angles to this. First, the U.S. has done considerable damage to the trust its allies had/have in it as a key partner. China is strategically positioned – given its ascension up the quality spectrum in many key areas – to step into the void in some of these areas as the U.S. pivots towards a more isolationist policy. China has long shown it is a formidable competitor in the AI race, and with this war, it has also displayed its renewable energy dominance. China dominates renewable energy supply chains – producing the vast majority of the world's solar panels, wind turbines, batteries, and EVs, and exports of these technologies were already climbing before the war. As the oil crisis pushes countries to accelerate their energy transitions, China is the primary supplier. The net balance clearly tilts in China's favor.
I think gold will continue to be a beneficiary of the ongoing shift from a unipolar world order to a multipolar one. I believe gold has been sniffing this out for several years now, which is why it’s been one of the best performing assets over the last three years. And while I don’t expect it to more than double over the next two years as it has over the past two, I do think it is an asset class that checks a lot of boxes for why it should be in every investor’s portfolio. Gold’s sell-off during the peak of the Middle East military tension puzzled some investors because it didn’t take on the defensive persona normally attributed to it. In reality, the March decline said less about gold losing its “haven status” than about the mechanics of a war-driven oil shock and the rush into dollar liquidity that followed.
Gold had already rallied hard over the past year because it remained central to reserve diversification in a world where the global order is becoming more fractured, so it was one of the few liquid winning positions that investors and central banks could sell when FX pressure and energy-import costs suddenly surged. We saw FX interventions in a number of countries including India, Poland, and Turkey, all of which are big net oil importers.
Turkey is the clearest example. As the Turkish lira came under strain, the central bank sold and swapped large amounts of bullion to raise dollar liquidity and dampen currency volatility before it could feed directly into inflation through higher import prices. The March slump, then, was not a referendum on whether gold remains a safe asset for geopolitical risk. It was a reminder that in the acute phase of a shock, even the preferred reserve hedge can become the quickest source of liquidity. The fundamental drivers of the long-term bullish story for gold are intact. Central bank demand will remain strong since gold reserves are proven to work as shock absorbers in FX markets, as well as serving as stable reserves in a world trying to find ways to diversify away from the dollar-based financial system.
One last thought before closing up this week’s missive. What has become clear over the past week is that equity markets are taking the worst-case outcomes off the table when it comes to the Iran war. This doesn’t mean they won’t be priced back in if they need to be, but given how things have evolved, markets are more focused on how things can go right rather than how things can go wrong. I am in this camp with oil prices acting as one of the key market signals adjudicating good outcomes vs. bad outcomes – oil prices <$100/barrel is the market saying things are okay, >$100 is the market’s way of signaling problems.
Bottomline, it’s important to be pragmatic and unbiased in measuring and mapping the markets at this juncture. Things are undeniably in a better position with little to no missiles going off than there were a week ago, but it’s not as though we are completely out of the woods. The worst thing you can be doing in an environment like this is changing your view every single day. Yes, be flexible with your view, but don’t give into the roller coaster ride of emotion with markets swinging up and down a percent a day. Be humble enough to know that you don’t and can’t know everything. Furthermore, a lot of what is happening is outside your control, which is why such environments are where most investors are likely to make really, really stupid mistakes. These are mistakes that could be avoided by simply being a little more disciplined and strategic in their thinking.
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