31 Oct 2023
This Merlin Weekly Macro looks at the appalling events in the Middle East and how markets have reacted, while asking what this could mean regarding US support for Ukraine.
Who knew that within 12 hours of our writing last week about US politics that the world had just become more dangerous than it already was, Hamas would launch its outrageous attack on Israel. Certainly, the Israelis did not.
The media is quite rightly fully focused on the humanitarian horrors of the Middle East crisis. Investors, meanwhile, seem so far largely to have taken it in their stride. This is no reflection of a lack of concern or compassion.
Whether bonds, equities, commodities or currencies, as we have written before, markets are most comfortable when quantifying and valuing things. When events such as we are seeing this week happen, they make a rapid assessment of the likely immediate economic and financial impact, with a scan over the longer-term contextual ramifications and outcomes, and discount everything back in relation to where prices are today; they then adjust accordingly. When they are deeply unsure, or are caught completely off-guard (as happened with Putin’s invasion of Ukraine, a Black Elephant event which despite the evidence they chose to discount as irrational, therefore it would not happen because in their minds it should not happen), they tend to fly to ‘safe haven’ assets: the US dollar, US government bonds, German government bonds etc. How ironic that US government bonds today might be regarded as bastions of safety given that for the second time this year, Congress is deadlocked in disagreement about how to rein in US government spending to avoid defaulting on its loans or withdrawing public services, and the administration is again suspended in a fixed period of official financial special measures pending a solution.
As it is, the past week has seen a slight retreat in both government bond yields and the dollar after nearly three months of concerted strength. As well as assessing the Middle East, markets have been reading the tea leaves of the Federal Reserve’s latest policy committee meeting minutes from September and digesting the accompanying Summary of Economic Projections (the SEP is the average product of every Federal Reserve official independently forecasting inflation, employment, growth, and interest rates, without collusion). While since June the SEP forecasts for inflation are little changed for 2024 (2.6%), 2025 (2.3%) and a new forecast of 2.0% for 2026 (magically, the Federal Reserve’s mandated target!), the median SEP projection for interest rates is less sanguine: using 5.6% as the base in 2023, the estimate for 2024 has risen from 4.6% to 5.1%, for 2025 from 3.4% to 3.9% and the new estimate for 2026 is a median rate of 2.9%. All represent positive real rates of interest when compared with inflation. None says that in the foreseeable future, from a policy-maker’s standpoint, nominal interest rates will return to zero whence they came.
But if rational-believing markets feel inherently more comfortable on their home turf of economics, finances and the reductive process of counting things, in terms of future risk they should not lightly discount the ramifications of this week’s geopolitical events and see them as entirely disconnected. The two are quite obviously interlinked.
At the risk of being repetitive, the lightning conductor of the current US domestic debt ceiling crisis upon which the market was fixated two weeks ago was the affordability of Joe Biden’s proposed incremental financial support to President Zelensky’s war effort. Now, the position has become significantly more complicated. As Biden commits to financial backing for Israel (which is officially designated alongside 17 other countries including Japan, Australia, New Zealand and South Korea a Major Non-NATO Ally, which affords them military aid but no explicit guarantee of protection), the currently rudderless and Speaker-less House of Representatives is refusing the bundling of the cost of aid to Israel with that also offered to Ukraine. Congress is saying these costs are not fungible: in the case of Ukraine, whatever Biden now allocates to Tel Aviv to help defeat Hamas, Republican hard-liners insist comes dollar-for-dollar out of the aid budget to Kiev and the campaign to defeat Putin. Crudely, the unresolved position is “we will afford one or other but not both; take your pick”.
The roots of the latest outbreak of hostilities are deep-seated but are directly related to the post WW1 policies of the League of Nations to manage the fallout from the disintegration of the Ottoman Empire. The creation of ‘Protectorates’ or ‘Mandates’ to maintain stability, handing direct responsibility for managing the internal administration and security in the Levant, Mesopotamia, Egypt, Palestine and parts of Arabia were primarily handed to France and the UK. Essentially with a clean sheet of paper, new countries were drawn on blank maps by civil servants, in some cases literally with a ruler, neat conveniently straight-lined borders inked in careless of geography, history or tribal and religious sympathies or antipathies. In the wake of the pogroms and the Holocaust, the imperative for a secure Jewish homeland, established on ancient Hebrew territory but then in the Islamic-dominated region of Palestine, and the self-declaration of the new nation state of Israel in May 1948 (when the British Protectorate expired), created an additional layer of significant complexity. The direct consequences are still entirely relevant today.
Amid competing and conflicting interests in the region, not only between the Arab world and Israel, but between Islamic countries themselves (and especially the religious divisions between the Sunni and Shia sects), it is the growing influence of both Iran and Saudi Arabia which are key to the future.
Heavily implicated in funding, equipping and orchestrating (or facilitating) the Hamas attack, Iran is a malign player of significant proportions, not least that it is now a quasi-nuclear state. Partnering with Russia, it filled the vacuum left by the western powers in the Middle East following the debacles of the Second Gulf War and the thoroughly wrong-headed joint French/British/American policy of stoking the Arab Spring uprising together culminating in the failure to act decisively in Syria when the Assad regime used chemical weapons. Today, Iran is supplying military drones and drone technology to Putin for use against Ukraine. Despite China having brokered a deal with Iran earlier this year partially restoring diplomatic relations with Saudi, it is believed that what Tehran could not countenance, given its stated aim of obliterating the State of Israel, was the prospect of the ‘normalisation’ of relations between Israel and Saudi.
In a thoughtful article in The Times this week, William Hague, former UK Foreign Secretary, warned that as Israel prepares a massive military response in Gaza with the explicit aim of destroying Hamas, it needs to beware falling into the trap laid for it by the organisation and its Iranian sponsors. In deliberately committing genocidal atrocities against civilians in the Jewish kibbutz settlements on the Gaza perimeter, with the knowledge (more accurately, the cynical intent) that hundreds of Palestinian civilians will be killed and injured in return, Hamas is trying to provoke a full-blooded response by Israel, to stoke up anti-Israeli sentiment worldwide. Further, while preoccupied in the south in Gaza, it allows another Iranian proxy, Hezbollah, to attack Israel in the north through Lebanon. With Israel in danger of fighting simultaneously on two fronts, it potentially creates a full regional conflict in the Middle East, sucking in neighbours. Even since Hague’s article, as western naval and air assets are dispatched to the Mediterranean and diplomats scurry to-and-fro trying to seek a peaceful solution, Iran’s embassies too are drubbing up military support for Hamas from proxies in Syria, Lebanon and Jordan.
And all the while elsewhere, there is already a major European conflict centred on Ukraine pitching NATO in a proxy war with Russia, and there are new simmering tensions in the Balkans and the Caucasus.
Incidentally, a senior commentator asserted the shallowness of China’s relationship with Iran, implying its irrelevance in this situation. Nothing could be further from reality. According to Kpler, a Vienna-based oil consultancy which tracks Iranian oil exports, China has trebled its oil imports from Iran in the last two years and, last month, it accounted for 87% of Iran’s total oil exports (all of which are subject to international sanctions); in reverse, Iran accounts for around 10% of all Chinese oil consumption. Further, without the co-operation of Tehran, China’s New Silk Road, prospectively bifurcating in Iran to extend south into Arabia and the Gulf, and west to the Mediterranean and thence into Europe, is simply a New Silk Cul-de-Sac. It would reach the dead-end roadblock between the Gulf and the Caspian Sea in the area completely filled by Iran. China is also heavily reliant on Saudi for oil (and with whom it has been colluding alongside Russia to disintermediate the US Dollar hegemon by allowing the settlement of oil contracts in currencies other than dollars) and claims to be a friend of Israel. It might so far be taking a neutral stance in the current conflict, but it is certainly not an uninterested party.
To be clear, political events in America and elsewhere are not the direct cause of the current hostilities this week. However, the timing and opportunism associated with the planning and execution of the attack are more than coincidental. To paraphrase Margaret Thatcher’s remark to President Bush before the First Gulf War when she famously said “George, this is no time to go wobbly”, the West is showing signs of wobbliness. Its foes, or those who would potentially do it harm, have made a judgement about its ability and resolve to confront them. Political wrangling and financial constraints; evidence of international divisions in NATO while pre-occupied in Europe; hesitancy about how to bring the Ukrainian crisis to a close; and the well-publicised knowledge that apart from the US (and even they are running short), most NATO members’ stocks of shells and missiles have been almost entirely shot away in 18 months of conflict in Ukraine with little hope of rapid replacement thanks to defence budget constraints and the capacity deficits of defence industries geared up for peacetime conditions, not wartime; all have contributed to malign forces taking their chance while the odds are less against them. Almost certainly the situation was compounded by the internal backlash against the new Netanyahu government’s radical policies resulting in mass protests, critically including by members of the reserve armed forces (if Hamas assumed that anti-government militancy would persist, it was a misjudgement: Israelis have rapidly rallied to the colours and any remaining steam has been taken out of the argument by Netanyahu appointing a National Unity Government in response to the crisis).
For the investor, the relevance is this: markets endlessly debate the future path of inflation and interest rates, and whether the latter will return to “rock bottom” (i.e. zero, as some believe should or will happen). However, it is as well to assess the longer-term risks, not least as we also embark on Lord Hague’s “revolution by coercion” on the path to carbon net-zero.
The US 10-Year Treasury is widely regarded as the proxy for the global risk-free rate of return on an investment. It is used when applying the discount rate in the calculation of valuing all assets and their prospective cash flows (the lower the discount rate, the higher the implied value of the asset, and vice-versa). In mid-2020 its yield was 0.5% (i.e. locking your money up with the US government for 10 years as a ‘riskless’ investment only needed an annual rate of return of 0.5% to be worthwhile); today it is 4.65%. In the light of the perceptible acceleration of the shifting of the global geopolitical tectonic plates with the uncertainty it brings, what is the appropriate risk premium in future? Virtually zero, as it was three years ago? Or where it is today, where the cost of borrowing at such rates is significantly stretching governments’ finances, such is the quantity of debt to which it applies? Or somewhere in between. It is a judgement call, not a science. But common sense says that while there are still many excellent investment opportunities, the overall risk outlook is greater today than markets were giving credit for in the very recent past.
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