Top of the Morning: CIO Strategy Snapshot - Shifting concerns
The desk emphasizes that geopolitical tensions, particularly the ongoing U.S.-Iran conflict, are exerting significant influence on market dynamics. As noted in the recent UBS commentary, the lack of a credible ceasefire has led to persistent uncertainty among investors, impacting oil prices and interest rate expectations. This situation has shifted market pricing from anticipating multiple Fed rate cuts to factoring in potential rate hikes, with the two-year Treasury yield experiencing a notable increase of over 50 basis points amidst a 55% surge in oil prices. With no significant economic events on the horizon, traders should remain vigilant about developments in the geopolitical landscape that may influence market sentiment, as highlighted by UBS source.
What the desk is arguing
The desk posits that escalating geopolitical tensions, specifically between the U.S. and Iran, are reshaping market perceptions and pricing. As articulated by UBS, the absence of effective ceasefire negotiations has heightened uncertainty, compelling investors to reassess their outlook on oil and interest rates.
Market adjustments have become apparent, with a marked transition from expectations of Fed rate cuts to a sentiment suggesting a 40% chance of a rate hike. This is underscored by the dramatic rise in oil prices by 55% since the onset of the conflict, which has in turn driven up Treasury yields across the curve.
Where it sits in our coverage
Our current consensus target for the currency pair stands at 1.075, aligning with the broader market sentiment where firms such as jpmorgan project targets as high as 1.10 and bofa leans towards a more conservative 1.04 for March 26.
This perspective underscores a divergence, with bofa at the lower bound, indicating a stark contrast to the more bullish outlook provided by jpmorgan.
How other firms see it
Several firms such as jpmorgan are leaning towards a more optimistic future, aligning with the increasing likelihood of policy shifts driven by geopolitical factors. Conversely, bofa remains cautiously pessimistic, reflecting concerns over potential economic impacts stemming from the conflict.
Traders should particularly keep an eye on the EUR/USD trajectory as it may reflect shifts in Fed policy, while the energy markets seem sensitive to any notable escalation of tensions in the Middle East.
01Geopolitical tensions are influencing market sentiment significantly.
02Recent data reflects a shift from expected rate cuts to potential hikes.
03Oil price surges correlate with shifts in Treasury yields.
04Lack of ceasefire negotiations contributes to market uncertainty.
Market implications
Traders should monitor oil price movements and geopolitical news, particularly developments related to the U.S.-Iran conflict, as these can significantly impact market sentiment and influence the USD's strength against major currencies.
Risks to this view
A sudden breakthrough in ceasefire negotiations could lead to a rapid de-escalation of tensions, prompting a sell-off in oil and a corresponding decline in Treasury yields, which would contradict current market positioning and expectations.
ubs
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. Last week brought reprieves to U.S. military strikes on Iranian power facilities, but not much in the way of credible ceasefire negotiations in the U.S.-Iran conflict.
That means uncertainty persists as investors are awaiting signs for either escalation in the conflict or de-escalation. Joining us here today to help provide some clarity is Jason Draho, Head of Asset Allocation for the Americas with the UBS Chief Investment Office. Jason, once again, thank you for dropping by on this Monday morning, today doing the podcast here in studio.
So great to be back at the table with you. Good morning, Dan. It's good to be in the studio again.
Absolutely. Now, Jason, let's begin with how the markets are responding to these almost daily changes in the conflict. Your latest blog entitled Shifting Concerns, it does suggest market pricing is shifting.
So how so and why? Well, a week ago when we recorded the podcast, we were talking about market pricing in what I would classify at that point was an inflation shock, stemming obviously from the massive surge in oil prices and that was sort of leading to a rate shock, but it wasn't really pricing and a kind of real growth shock. And you can look at the market pricing from when the conflict began, so taking February 27th, right before, that was a Friday right before it began, to say now about 10 days ago, what was the market doing?
Oil prices were up 55%, 50%. The market went from pricing almost 2.5 Fed rate cuts this year to now pricing at that time a 40% chance of a rate hike. The yield curve or yields across the whole curve went higher.
So the two-year treasury yield had been up over 50 basis points. The 10-year up on about 45%. And equities are down 5%, which is relatively modest when you consider that moving rates just mechanically kind of finance one-on-one will tell you your discount rate, your cost to capital goes higher.
Equity valuations go lower once you factor that in. The growth component of the equity decline is only a couple of percent. And defensive sectors weren't really clearly outperforming.
So that was where we were a week ago. I think if we start to look at price action last week and particularly kind of culminated on Friday, you start to see the market shifting a little bit and still sort of worried about inflation but now getting a little incrementally more worried about growth and how this conflict could last a long time and therefore wail on growth. Just to give you some data points of why I think that was the case.
So on Friday, we saw the market pricing still for a hike but down to 30% as of Friday. But on Thursday, it was at 60%, so a significant sort of change there. The two-year treasury yield was down at six basis points on Friday.
All this was despite oil prices going about 6% higher. Now that was actually the first real sign of a negative correlation between oil prices and the two-year yield in a number of weeks. So they basically have been moving lockstep.
Higher oil goes, the higher the two-year goes because the market is pricing more kind of fed cuts or more restrictive policies you ship in that direction. When that correlation goes from positive to negative like it did on Friday, that to me is a sign that the market is starting to get a little more worried about growth versus inflation. As a result of that, gold rallied 3% after selling off quite a bit.
Gold obviously is going to be sensitive to the interest rates, the sort of opportunity costs. So if your funding cost of cash or short-term interest rates goes lower, gold also can go higher. Then also on Friday, we saw the S&P was down almost 1.7%.
Its cumulative decline since the conflict began was 7.5%. We saw that especially Friday but also Thursday, defensive sectors were really kind of clearly outperforming like utilities, consumer staples. So Friday, just one day, but it's sort of starting to see some cracks in what is driving markets.
Now Monday morning, we're seeing rates go lower, equities are going higher. This is very early as we're kind of recording this on a Monday morning. Perhaps unwind a little bit of the de-risking on Friday.
Perhaps it's some optimism of continued, at least tweets from President Trump regarding positive negotiations. Iranians don't seem to be backing that up but I think the market is maybe taking a sign that a couple more weeks and this will wrap up. But that's kind of where we are.
Now just in terms of why the market went from pricing more inflation shock to a growth shock, the lack of a clear progress towards a ceasefire that would open up the Strait of Hormuz and allow more oil to go through, I mean that's somewhat concerning. Like delaying any military action on Iranian infrastructure and power production. It's a positive.
I mean it's certainly not a bad thing but it does mean that this sort of drags on longer. There's more uncertainty and as the further we get into oil in April, the more the concerns are that this is going to be sort of a nonlinear disruption to oil markets. It just takes longer then to kind of recover.
So the longer this extends, the more this risks not just being an inflation shock but being a growth shock as well. So I think that's kind of where the markets want to see this wrapped up. I mean I think we all would for a variety of reasons.
The longer it persists, the more I think the markets get concerned about how disruptive this could be for the economy overall. So a very fluid headline environment at the moment and that reflects in the markets and if we turn to the economic environment, Jason, there will be more intense focus on economic data as growth concerns rise. What does the current data tell us so far about the impact and what are you watching for in the data to be released this week?
Well, we still don't have much data for March but that's going to change beginning of Wednesday because Wednesday is April 1st and then once we get into next month, the calendar turns, we start to get data from the prior month. So this is going to start to shift. What we have seen thus far is things like survey data of consumer confidence that occurred in March.
So it does incorporate the impact of this war beginning. That has taken a hit, not dramatically so but it's certainly taken a bit of a hit. There's not real concrete evidence that consumer spending has been adversely impacted in some way.
We will get retail sales released also on April 1st on Wednesday but it's for February. So again, it doesn't really reflect what's happened since that point in time. Higher frequency data like on credit card spending doesn't really show much material impact.
Again, it should be shifting some consumption from goods to perhaps just filling up your tank with gas but overall, not a material impact at least just yet. The more significant data points that we're going to get this week include the ISM manufacturing survey on Wednesday. That was done in March so it will kind of reflect some of the latest developments.
Consensus forecasts on Bloomberg suggest it won't change from February so still in positive territory and then some of the regional manufacturing surveys that came out in March said a little bit more real-time. That can sometimes be a precursor to what the ISM suggests. Collectively it can point to an ISM holding steady.
So if that plays out, that's a positive. And then on Friday, which is a good Friday, so the markets by and large will be closed, equity markets, we do get the March payrolls report. The consensus forecast is for $60,000.
This comes after the January payrolls report that was at minus $92,000. Now there were some anomalies to the January data. There were some strikes going on that subtracted an estimate of about $30,000.
Those strikes are over so mechanically that can add to the March payrolls. Also when the data was being done for February, it was cold, there were some storms that could weigh down the estimates. March, the weather was better.
The survey week was warmer so you can actually see a pull forward in spring hiring, for example. So the view seems to be that the number could be higher. Some estimates are $100,000 plus.
If it is in that range, it at least alleviates some of the near-term labor market concerns. If it's another minus $92,000, that would be a real problem. But if it goes the other direction, for the time being, that helps.
Ultimately this is still early on the impact so it won't solve all the problems of growth concerns because if it takes time to accumulate, the pain from higher oil prices, higher gas prices will start to build in the spring and in the summer. But these are things to watch for. It will help if it's good, but it's not a game changer at this point in time for the overall outlook.
So going back to your blog for a few moments, Jason, again that title Shifting Concerns within your blog, you do note that there are echoes to 2022 because that year also experienced an oil price shock and an inflation shock. But you also say that there are important differences to be mindful of. So what are they, Jason, and why does that matter for the investment outlook?
Just to recap what happened in 2022, Russia invaded Ukraine around the end of February. Oil prices surged at that point in time in response to various restrictions by the US and other allies to curtail what Russia can sell. So there's an oil price shock.
We also think about what happened that year. Inflation was already surging and this is an important difference between today versus that time period. Headline CPI inflation was over 8% in 2022 when that oil shock began in February.
Ultimately, inflation went up to 9%. It might have got there regardless of whether the conflict began, but it was very high and rising. Today, headline CPI, the latest data we have for February, is at 2.4%, so a very big difference there.
Interest rates were much lower back in 2022, so it's hard to imagine. But when that conflict began, the Fed was basically still just winding down its QE purchases and the Fed funds rate was still kind of between like 0 and 25 basis points. And the 10-year yield was below 2% in the early part of that year, as low as 1.67% I believe at the start of 2022.
Conditions are very different now on interest rates. The 10-year was around or over 4%. The Fed funds rate between 3.5%, 3.75%, obviously much higher.
And by estimates in neutral, I'd say it's still slightly restrictive versus incredibly accommodative before. There were other inflation forces back in 2022 that sort of had the Fed very focused on it. You know, the job growth, we just talked about what we're hoping for this year.
In 2022, non-farm payrolls averaged 377,000 jobs per month. It's a very different labor market dynamic. Fiscal policy was still very loose.
There's, you know, the CHIPS Act were passed, infrastructure, you still had stimulus from the American Recovery Act. So a lot of fiscal stimulus helping. And then the supply chains globally were still recovering from the pandemic.
And you can see the supply chain was probably the biggest driver of why inflation kind of surged, you know, when it did. That's not an issue globally at this point in time. So the inflation risk is much more concentrated on oil prices going higher, which affects headline a little bit much more less on core.
Labor market is definitely softer today. And you know, the Fed policy is already a little bit restrictive. So from the Fed's perspective, in 2022, they were way behind the curve.
They had to focus on tiny financial conditions to bring inflation down. Labor market was strong, so they could sort of unilaterally focus or singularly focus on the inflation part of the mandate and ignore the labor market. Today, it's a different situation.
Inflation risk is not as bad. Growth risks are worse. So they can take a more sort of balanced approach.
So the tightening that they had to engage in terms of financial conditions, much less need to do that this year. So as a result, I think the impact for the overall markets and the cross-asset classes should not be anywhere as bad then. There still could be some drawdown risk.
The S&P 500 peaked a trough decline in 2022 was 25%, but that accrued over nine months. You know, it peaked on January 4th, and it wasn't until October 12th when the markets hit a bottom and started to recover. Over that same time period of roughly nine to nine and a half months, U.S. government bonds kind of in total were down 13% because rates were just so low.
This time, rates, they just hold steady, you're going to get a positive return there. So I think that's just, it's a very different environment. The conditions, the macro conditions are different.
The risk of inflation isn't as bad, the risk of rates going higher from the starting point much less. And so, yes, it has some similarities to 2022, but I think for portfolios, this, you know, it's a much different situation this year than it was that year. So with that context in terms of what to do as far as positioning in this environment, and we talked about how it remains fluid with headline risk, let's end today on investment recommendations.
Jason, what are you conveying to investors right now? So just, you know, this is all very hard to predict. It's a very fluid situation, and the daily newsflash kind of ebbs and flows between maybe some positive signs of de-escalation to signs of escalation.
At a minimum, the longer it sort of takes to resolve, you know, kind of in some sense, the worse it is for the markets because investors really dislike uncertainty, and having uncertainty not being resolved, that starts to weigh on sort of investor sentiment, you know, overall. It's also the case, as I mentioned, the longer it persists, the greater the risk of a growth shock. And if it's a growth shock, that is negative for risk assets across the board.
There could be certainly more downsides, so I don't want to, you know, underplay that possibility. Now, if there is a silver lining to this, you know, from a market's perspective or a portfolio perspective, if investors in the market start to become a little more worried about growth, traditional portfolio diversifiers start to work a little more effectively. And I go back to, you know, the numbers I was setting for last Friday.
When investors perhaps were getting more worried about growth, you saw is, you know, bond yields by large declines, so bonds were helping provide some diversification. Lower rates helped gold, so gold was providing some diversification. And again, more defensive equities like utilities were helping to provide some more diversification.
When you're worried about an inflation shock and that's dominating things, it's kind of bad across the board. Everything kind of tends to sell off. Where if it's a growth shock, some things can at least perform even better on a relative basis.
So at least you can start to hedge your portfolio a little bit better. So I think that's, you know, something to keep in mind. So some of the ideas, the recommendations, you know, that we've been talking about is, I think, are consistent with that.
The other thing is, ultimately, because this is really hard to predict and it's difficult to trade geopolitical events because you never know exactly when things will end, that the best course of action is still to stay invested, you know, kind of stay around sort of a long-term strategic benchmark. Make sure you're diversified. And sort of, you know, when we say kind of de-risk, what we mean is, if you're aggressively overweight risk assets or tilted in one area, make sure your portfolio is not taking on excessive risks in a certain area, sort of getting back to a more balanced, diversified portfolio.
So, you know, that's kind of the overall view. On a 6 to 9 month perspective, again, we still think, ultimately, the U.S. economy grows, you know, around, you know, 2-ish percent this year, earnings growth still could be upwards of 10-plus percent. All these things are supportive, you know, for equities.
But in the near term, until we get some sort of resolution with this conflict, things could get worse over the next two to three weeks before ultimately you get a flipping point. So, you know, be prepared for definitely more volatility near term, but ultimately kind of longer term, we still remain, you know, relatively kind of positive on the outlook. So, if you're a long-term investor, that's, you know, kind of against de-invested.
Well, Jason, just given the fluidity, as we've said, of this all, a lot of headline risk out there. Very helpful guidance this morning. Thank you for dropping by to touch base with our listeners, our clients, and do look forward to picking back up with our conversation in the week ahead.
You're welcome. Have a great week. Thank you for tuning in.
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