Andrew Pyle
October 13, 2023
War and Markets
Less than a week ago, we were horrified by the images that showed up on our screens when Israel was attacked by Hamas. This was not foreseen by anyone in the markets, but the catastrophe and war that has ensued this week only added to the level of anxiety felt by investors. Our hearts go out to all of our clients and friends who have been impacted by these tragic events.
In the days leading up to the assault, both equities and bonds were already shaky. The TSX and S&P500 had just suffered their worst two-month declines since September of last year (5.3% and 6.6%, respectively). The same held true for Canadian and U.S. bond markets, as both universe indexes lost more than 3% over the two months.
With Middle East tensions on the rise, many investors have asked whether this market weakness is going to be reinforced. To answer that question, we need to separate the direct impact of military conflicts on financial markets from the potential indirect effects. A number of studies have been done, examining movements in global capital markets during conflicts and most have come back with the conclusion that stocks have not largely shown any correlation with these types of events. That’s not to say that there have not been any instances where markets fell in response to a conflict. The 9/11 terrorist attack is a good example where equities initially fell in response; however, there have also been incidences where stocks went up. That is why analysts who have studied conflicts since WWII, have been unable to arrive at a definitive correlation.
At the micro level, there are divergences in the equity market that would seem intuitive. For example, if the scope of the conflict is severe, then the assumption would be that military spending would rise. Indeed, we saw that this week the S&P Aerospace and Defense index outperformed the S&P500 by a factor of 2 to 1. As the above chart shows, the divergence was even more profound back in the first quarter of 2022, when Russia invaded Ukraine. Where the S&P500 had lost more than 10% from the start of the year to the first week of March, the aerospace and defense index was basically flat. By the end of March, the latter was up close to 8%, while the benchmark aggregate was still in negative territory.
On the commodity side, we would expect that a Middle East conflict would cause oil prices to rise, and that theme has been raised this week with respect to Iranian supplies or simply the ability of crude to flow through the region. Well, WTI futures had peaked near $95/barrel at the end of September, before falling below $85 just before the attacks. There was an initial jump after the weekend, but we headed into the weekend just north of $83. Gold has demonstrated more of a predictable move in the wake of the atrocities, bouncing from intraday lows just above $1800/oz to the $1870 area by Thursday. I would argue that the market was just looking for a reason to buy back into bullion, especially with $1800 representing a technical support level since the start of the year. In addition, the yellow metal has been pressured by a renewed strength in the value of the U.S. dollar which, if you believe that the Federal Reserve’s monetary stance is going to loosen at some point in 2024, is probably going to backslide.
Irrespective of the spurious reactions by some markets to conflict, let’s step back and examine the current situation in the manner that every preceding event should have been. Before and after a conflict, there is the macro framework. A country, or the world for that matter, might be in a state of recession or rising inflation. It will have been on a trajectory before the conflict and, unless the conflict’s impact was wide-reaching, that trajectory may not have been altered. There have been graphs displayed that show a market’s response at the time of a conflict as corresponding to what we might have expected, only to ignore the fact that the weeks, months and quarters leading up to the event had already told us what was going to happen.
Today, we are transitioning from a pandemic-induced economic distortion of high inflation and tight labour markets to one that is normalizing under the weight of high interest rates and increased uncertainty over the business environment in front of us. Lest we forget, there is still an automaker strike going on in the U.S. and the beloved House of Representatives can’t find a speaker. Russia is still in Ukraine, COVID is making its rounds again and the war against inflation has not yet been won. In other words, there are a number of elements that cloud the outlook and prevent optimism from rising.
Prior to this week’s events, we were actually seeing some light at the end of the tunnel. Even though consumer confidence was depressed, business sentiment was starting to germinate. The ISM Manufacturing PMI had reached a low of 46 (anything below 50 is technically a contraction for U.S. manufacturing), but it had moved up to 49 in September. I would think that the October reading will be low and resume the correction from levels seen in 2021. That is an important takeaway. Before this week, there was already a slowing momentum in the U.S. and Canadian economy. Whether you are in the recession camp, a believer in the soft-landing world of Goldilocks or think that there is not a landing at all in the cards, the heightened risks from the war in the Middle East has likely scaled your view to the downside.
So, we don’t think there is a major direct impact from these developments on markets, but there is a chance that economic paths become less certain or simply worse. What is the appropriate portfolio strategy in this? In our opinion, it’s not much different than the strategy we had going into October. This season was going to be problematic to begin with. Keeping cash on the sidelines to deploy into either equities or bonds or both on a major setback was prudent.
The one thing we have spoken to clients about during these times is to avoid moving from one side of the ship to the other. Artificial intelligence was going to propel markets to the moon this year, and it looked like it might, but investors realized this was a longer-term (though still viable) game. There are weight loss pills on the market that have everyone from airlines to clothing makers excited, but no one has really talked about the negative consequences when the pills are stopped.
It is the indirect effect on business and consumer confidence from developments before the attacks on Israel and afterward that will have the greatest impact on market direction for the remainder of this year and into 2024.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew Pyle
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Andrew Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. He and his clients may own securities mentioned in this column. The views of Andrew Pyle do not necessarily reflect those of CIBC World Markets Inc.