Now that we are a fortnight into the Middle East crisis, investors might scratch their heads since not all actions in the financial market appear to be following the historical playbook. Given the magnitude of the conflict and its potential for spillover, one would have imagined a major risk-off move and a flight towards safety.  This would normally see a deterioration in general equity market sentiment, a push into currencies like the U.S. dollar (and perhaps also the Swiss Franc), along with an increased demand for bonds and gold.  Some of these have transpired since October 6^th, when Hamas attacked Israel, but some have not. Let’s start with currencies and commodities.

 

Has the American greenback improved over the past couple of weeks?  It has, but I don’t know if I call a 0.1% rise in the DXY dollar index a “rally”. In fact, the dollar has lost ground against many of its G10 peers – most notably the Swiss franc and Swedish krona. Indeed, as the chart below shows, the franc has shown a steady improvement since the start of the month, compared to the lack of conviction displayed in the dollar index overall.

 

 

 

Thank goodness for gold.  That bastion of wealth preservation, in the face of chaos, has lived up to its reputation, rallying close to 10% since news of the attacks.  In our conference call just before the crisis, I spoke about how gold needed technical support just above the US$1800/oz level to hold after the sharp slide in September. The current situation has not only prevented a slide below this mark, but it has taken gold up towards US$2000 for the first time since July. Barring a ceasefire, analysts believe we could go and re-test the highs above US$2050 last seen in the Spring. True, crypto currencies have also benefited, though I would still argue that if this crisis becomes protracted and more damaging to risk assets, then the likes of Bitcoin will not be able to match gains seen in gold.

 

 

 

Then there is oil. Recall that even before the crisis unfolded, WTI futures were already testing up in the US$95/barrel area on concerns over tight inventories and stronger-than-expected economic activity. Those that had written off oil back in the first half suddenly had to reverse course as the break above US$80 in August turned out to be less of a mirage than some thought. In the first week of October, futures had experienced a sharp slide back towards US$80 and, similar to the gold story, the crisis created a bounce. That bounce has now taken us back above $90 for a gain of about 11% at the time of writing.

 

 

 

On Thursday evening, President Joe Biden gave only his second oval office address and proposed that Congress agree to US$100 billion in support for not only Israel, Ukraine, but also Taiwan. This followed news that U.S. bases in Syria and Iraq were now being targeted and that there were interceptions of missiles fired towards Israel from rebels in Yemen. The prospect of an expansion in hostility will raise the spectre of supply disruptions in a number of areas, including oil. This could mean a move in crude up through US$100 and potentially to the post-pandemic high water mark above US$120. Again, the direction that gold and oil have taken are fairly intuitive, albeit mild. The same holds true for stocks.

 

 

 

Global equities were already backsliding since the middle of the summer, as shown in the above chart. The MSCI World index had fallen roughly 9% from the intraday peak in late July to the low witnessed on October 4^th. On the Monday following the attacks on Israel, the index had actually moved higher and continued to improve right up until last week. In the last couple of days, nerves have frayed and we have seen equity valuations in most markets retreat back to below the early-October lows.

 

If we look at the S&P500, it will probably surprise you to know that 40% of the companies were up from their close on October 6^th as of Thursday. Yes, 40%. The companies that were at the front of the pack were in the industries you would imagine – energy and defense. Outliers included the likes of dollar stores and a well-known yoga/athletic ware company. Among the largest decliners in the S&P were again what you would expect – airlines, cruise lines as well as some pharma companies.

 

Back in the second quarter, investors pinned their hopes (even if they weren’t doing it consciously) on the “big 7” – those mainly tech-related mega cap stocks that generated almost all of the lift in the S&P500. Looking at these same companies since the start of the crisis is interesting. First of all, only 3 of the 7 are still up and only Microsoft is up more than a percent. Contrast that to declines of 15% in Tesla, 8% in Nvidia, 1% in Apple and a 0.8% drop in Meta Platforms. The leadership appears to have disappeared but, if you look beneath the surface, the stocks that have proven to be more resilient in the last two weeks (outside of energy and defense) are those with solid balance sheets and a ton of cash. Apple would be the exception, but this has more to do with weak initial sales numbers for its iPhone 15 than the Middle East. The cash issue is important and is playing a role in the allocation of capital by investors as we move through this crisis.

 

 

 

Often when we think of “quality” investing, we are talking about balance sheet strength as one of the key measurables, but even if a company was rock solid, there have been times when investors reacted to a geopolitical crisis by selling and looking for something with an absolutely stronger quality characteristic. That would be a U.S. government bond.  This is why we often see domestic and international flows move into the U.S. dollar and into the largest and most liquid bond market in the world. The dollar would rise and bond yields would decline. Not so this time around. Even with chaos on the doorstep, the U.S. 10yr treasury yield tested 5% this week.

 

There are a number of reasons why bonds went against the playbook. To start with, the U.S. economy is still showing signs of strength. Initial jobless claims fell back below 200,000 and retail sales came in better than what economists predicted.  Consumer and produce prices continue to rise at a clip that makes the Federal Reserve uncomfortable and, to top it off, Fed Chair Powell stuck to the higher for longer mantra at a speech on Thursday. His comments shouldn’t have been a surprise (though it might be nice if there was less central bank banter during these tense times), but investors were not ready to go by the safe-haven playbook like in the past. Rather than move money into bonds, the collective decision appears to have been to raise cash, buy energy and defense stocks and stick with quality / high cash balance companies. There is also heightened concern over the lack of fiscal discipline and demand for new issuance at upcoming treasury auctions.

 

 

 

The last item to look at is what is happening to market volatility. Understandably, investors this weekend will be thinking about their portfolios and how gyrations have returned. It was just this past September when the U.S. CBOE VIX index had fallen to its lowest level (around 12) since right before the pandemic. It started to climb prior to the conflict, but it broke above 20 only this week and remains below the highs seen in 2022. Are we to conclude that a rapid tightening in monetary policy last year is going to have more impact on volatility than another war?

 

I think it’s way too early to answer that, but there is one thing that investors should keep in mind when looking at volatility measures, like the VIX, to evaluate the real underlying shakiness of the market. Recently, there has been a strong flow of capital into so-called “short vol” securities. This simply means the selling of options, whether calls or puts, as part of an alternative approach to traditional vehicles where we just buy equities and bonds. Contrary to buying options (“long vol”), where you might even accentuate a rise in market volatility, the proliferation of option-selling securities might be depressing observed volatility.

 

I know that is a little technical, but suffice to say that we need to be looking at a broad array of indicators to ascertain just how much of an impact this current conflict is going to have on both equities and bonds, and which sectors we need to shift into to protect capital until we get on the other side.

 

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.