Merlin Weekly Macro: Why are markets acting so calmly?

A Little Green Man landing from Mars and studying the markets would be hard-pushed to know the world is its least stable geopolitically since the end of the Cold War, and becoming less stable.

Oil: a rising price but so far no panic

On the anniversary of Hamas’ attack on Israel’s Kibbutzim, when it spiked to $90 per barrel, today the price of Brent Crude Oil is $78 per barrel. It has risen $8 over the week since Iran launched missiles directly into Israeli territory, but compared with Putin’s invasion of Ukraine in February 2022 when the oil price leaped to $120, or a year ago on the Hamas attack and April this year when the Iranians made their first direct missile attack on Israel and on both occasions it spiked to $90, so far the response has been relatively muted. Usually, the oil price is a reliable barometer of economic sentiment, particularly when the Middle East is the centre of attention. Examining the oil price, you would be forgiven for believing that there was a little local difficulty rather than, as is rapidly evolving, a conflict across the region that is not only literally exploding but spreading north into Lebanon and 2500km south into The Yemen as Israel takes on anyone and everyone inflicting harm on its homeland and people.

In Ukraine where the redoubtable and remorseless President Zelensky has been rebuffed again by President Biden about the possibility of using long-range missiles against targets inside Russia, thus almost ensuring the war goes on ad infinitum without a clear winner, markets did not miss a beat. Zelensky’s pleas were stymied by Vladimir Putin changing the terms of engagement about the use of tactical nuclear weapons: any missile fired into Russia which was sourced from a NATO nuclear power (i.e. the US, the UK and France) would immediately legitimise Putin’s use of tactical nuclear weapons in response. Is it a bluff? Joe Biden wasn’t prepared to call it.

Markets pragmatically concentrate on change, not more of the same

Markets focus on specifics that are quantifiable and upon which values can be placed. Counting and calculating are their comfort zone. Most else is noise: interesting as context but of no great relevance directly until an event jumps up, slaps them around the chops and forces them to take notice. Putin’s initial invasion in February 2022 was a good example: it was deemed irrational by investors therefore, with false logic, it would not happen. When it did, they were taken by surprise and forced to recalculate the new scenario and its implications. The Hamas atrocities last October were another: a shock prompting an immediate reaction (higher oil prices; a significant blip in sovereign bond yields reflecting the additional risk, followed by an assessment and a pragmatic evaluation of what, if anything, had changed that would affect the prices of equities, bonds, commodities and currencies).

What would shock markets from here? A big escalation in the Middle East should be such an occasion, even though it is already recognised as a possibility. A direct Israeli attack on Tehran’s oil and nuclear infrastructure would almost certainly create volatility, especially given the possibility of some form of nuclear escalation, or China, Russia and America becoming involved. Iran accounts for 4% of global oil production which would upset a finely-tuned and sensitive oil market, albeit investors are currently discounting Saudi and other OPEC (Organization of the Petroleum Exporting Countries) members ramping up production to make up the shortfall. Elsewhere, China invading Taiwan, putting at risk 90% of the global supply of microchips, would be an immediate problem. Nuclear escalation in Ukraine now that Putin has changed the terms of engagement as discussed above would be an obvious change.

However shocking to our sensibilities such a cold approach to death and destruction may seem (markets see themselves as rational and pragmatic, preferring not to deal in emotion), the status quo of world events does not shift the dial; only something quite different to today does that.

Investors stick to their knitting: inflation, growth and interest rates

If the military action is only too evident on our television screens, the financial battleground remains inflation (or the lack of it compared with 2022 and 2023), and interest rates that are deemed unnecessarily high. In the US they are perceived by some to be at risk of forcing a needless recession. It was a relief that in September the US Federal Reserve at last jumped off the fence and joined the European Central Bank and the Bank of England in beginning to cut interest rates. It opened with a seemingly aggressive half percentage point reduction. If markets were hoping for a second half-point cut in November, Fed Chairman Jerome Powell subsequently tempered the mood, implying a greater likelihood of two quarter-point cuts before the year-end. Not helping form a judgement on the immediate outlook is data pointing in opposite directions: the most recent jobs report suggests the economy is cooling; on the other hand, the forward-looking business confidence indicator for the US services sector soared to 54.9 in September, up from below 52 in the previous two months and below 50 in June; a figure higher than 50 suggests (rather than predicts) economic expansion in the sector, while below 50 suggests contraction. That the figure is rising indicates an acceleration in economic expansion.

‘Are we there yet?’

It is not just the US under scrutiny. Here in the UK, the Bank of England Governor Andrew Bailey said in a speech that he would like to see UK base interest rates being cut more aggressively (the decision is made by committee, not by him alone: he is publicly leading the witness). His comments immediately prompted a significant weakening in sterling. This was followed by his chief economist, Huw Pill, being sent on a damage limitation exercise around the newsrooms, effectively to say that his boss didn’t quite mean it that way and he had been taken out of context. If the chief mechanics of monetary policy are publicly at sixes-and-sevens, it is hardly surprising that investors are confused about how quickly we reach the destination with interest rates, even if everyone largely agrees on the direction of travel.

Phase Three in the interest rate war

This is what we may regard as ‘Phase Three’ in the post-Covid, post-Ukrainian invasion monetary policy response. Phase One: markets rapidly pushing up yields on government bonds (yields and interest rates broadly move in the same direction while bond prices move the opposite way), telling the central banks to wake up to the incipient inflation crisis which was in danger of getting out of hand. Phase Two: where would interest rate peak and for how long would they remain at a plateau? Phase Three: how aggressively they are cut and over how long?

Each Phase represents a battle of wills between the markets as providers of capital, and the central banks who set the benchmark cost through the interest rate. It is about who controls monetary policy when the two sides are approaching a common object from two completely different perspectives: the markets’ preoccupation with risk and making money; the central banks’ about delivering an economy with a stable 2% inflation rate. Differences in opinion are reflected in volatility. With interest rates now reducing, there are opportunities to make money but it may yet be a bumpy ride along the way.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.