Issue 105: Middle East Fears Grow

This Week’s Highlights

• Middle East conflict intensifies
  Fears that Israel’s impending response to an Iranian missile attack could plunge the region into all-out war led to a risk off by the end of last week, with the VIX “fear index”, the US dollar, and crude prices rallying back after falling on the heels of September’s Fed cut.
• Monster September jobs report
  If the argument for a half-point cut at the last FOMC hinged on perceptions the job market was in bad shape, last month’s nonfarm payrolls will force the Fed to carefully consider its November move, as new hires far exceeded consensus forecasts to the upside.
• Look to EM stocks as Fed eases
  Between the Fed’s recent pivot, the possibility of a US soft landing, and seemingly better odds for China’s return to growth, emerging market stocks—not least some of those outside China—find themselves in an increasingly good spot for outperformance.

The CIO’s Take:

• It’s remarkable to us—and a sign of just how optimistic US equity investors have been—that despite an increasingly dire situation in the Middle East, the VIX presently sits below its long-term average. We hope for the best, but feel better knowing our models’ exposure to commodities, including energy, helps hedge just such geopolitical risks.
• We’ve long been skeptical of markets’ assessment that the Fed is ready to keep the jumbo rate cuts coming. With September jobs data showing an obviously resilient labor market, although we won’t go as far as some others in labeling the Fed’s half-point September cut a policy error, we do believe they will now moderate the pace of easing.
• Robust labor market data also strengthens our baseline call for a soft landing, which we expect to boost EM stocks in the face of Fed easing, dollar weakening, and a potential recovery in China demand. Indeed, conditions seem right for EM outperformance versus DM stocks: in other words, international diversification doing its job!​​​​​​

Middle East Fears Grow

Israel, Iran on the brink of war
One year on from Hamas’ tragic October 7th attack on Israel, tit-for-tat actions between America’s principal ally in the Middle East and Israel’s longtime foes—namely, Hamas, Hezbollah, and their backer, Iran—has threatened to become a regionwide war. Since mid-July, when an Israeli airstrike killed Hamas’ military wing head, Mohammed Deif, the situation has rapidly deteriorated. It seemed to reach a tipping point last Tuesday when an Iranian barrage of nearly 200 ballistic missiles sent most of Israel’s 10 million people into bomb shelters. Here we examine the economic implications.

Traders pricing in some pain
Simply put, the fear is that a worst-case scenario—full-scale regional war—would send energy prices sky-high and send financial markets into risk-off mode, creating a drag on growth and exerting upward pressure on prices at a critical moment on the Fed’s path to a hopeful soft landing. That anxiety was clearly reflected in financial markets last week, as Iran’s missile strike sent the VIX “fear index” surging, prompted a spike in the safe-haven US dollar index, and gave Brent crude futures their largest weekly boost since January 2023 (see below).

As the rightmost plot above indicates, gold showed perhaps less of a ‘flight-to-safety’ response than some might have expected: though, that’s understandable given the precious metal had been climbing for weeks on enthusiasm for the Fed’s pivot to easing, including a string of all-time high prices set over the third quarter.

Oil could reach $100 per barrel
Oil is the one we’re watching most closely. We’ve commented before on what we believe is an underappreciation of how quickly prices might rise if demand turns out to be higher as a result of a US soft landing—not to mention a potential stimulus-induced economic recovery in China—against a backdrop of relatively tight supply. Biden’s admission last week that he was speaking with Israel about potential retaliation on Iran’s oil production infrastructure revealed another threat to supply, one that Bloomberg Intelligence estimates could quickly send oil prices up to $100/barrel.

And yet, VIX still relatively low
In this case, it’s arguable the leftmost plot above provides the most useful insight. Sure, the VIX spiked as traders braced for impact of Iran’s missile salvo, but it didn’t rise to levels reached a month earlier, when markets were deliberating whether the Fed would settle on a quarter- or half-point cut to US interest rates. Zooming out, the VIX’s closing value as of last Friday of 19.2 was actually just below its long-term average of 19.5. In our view, that underscores just how much positivity is baked into prices at this moment, despite a wide array of very real risks.

Jobs Data Looking Up!

In Fed strategy, labor looms large
As we discussed in the wake of the September FOMC, jobs data served as critical support for the Fed’s decision: not only to cut rates when they did, but also to front load the easing process with a 50-bps move. In particular, a Bureau of Labor Statistics (BLS) report on July jobs, released after the Fed’s July meeting, showed the labor market loosening and seems to have given the US central bank a bit of a scare. Last Friday brought another installment of monthly BLS data, though the picture painted by this set of stats wasn’t nearly as bleak.

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Surprisingly strong September data
Indeed, it was a banner month, with the US economy adding 254K jobs in September, a figure topping all estimates, obliterating the consensus forecast of 140K new hires, and surpassing August’s upward-revised total of 159K jobs. The unemployment rate likewise ticked down from 4.2% to 4.1%. Services drove job gains, logging 202K new hires, including 78K in leisure and hospitality, as well as nearly 72K new jobs in health care. Construction was another sector adding workers, up 25K jobs for the month, while manufacturing lagged, actually losing 7K workers.

25-bps nearly certain in November
Those investors back in July calling for a sequence of jumbo rate cuts under the premise that America’s labor market was going over a cliff presumably thought twice after last Friday’s data. Just one week prior, the market-implied likelihood of another half-point rate cut stood at over 53%, according to CME Group; as of last Friday, that probability was down to zero, with a 5% implied chance of no change at the November FOMC. We stand by our original view that labor is softening from a very strong spot, and that the Fed is likely to cut 25 bps at each of its next two meetings.

For those who don’t trust the data…
There are a few interesting caveats worth mentioning for ultra-doves among our readers, looking for reasons to doubt September’s strong jobs. For one thing, unemployment benefit claims rose more than expected in September. For another, the BLS report figures most widely cited are seasonally adjusted, and September’s seasonal adjustment factor, some have noted, was the largest ever (see below), giving September nonfarm payrolls a bigger-than-usual boost.

The response rate to the BLS survey last month of just over 62% was the lowest September figure since 2002, suggesting the potential for a big revision when more results trickle in. On the other hand, the ISM’s September Services PMI came in at 54.9, higher than August’s 51.5 reading, and well above the consensus forecast of 51.7, corroborating strong job gains in the services sector and suggesting to us the economy really is that robust: great news for the Fed and anyone else cheering for a soft landing.

A Stronger Case for EM

Declining dollar often sees EM outperform
Earlier in this week’s commentary, we touched on one implication of frayed nerves over Israel’s response to Iran: US dollar strengthening in a ‘flight to safety’ by global investors. It’s apparent from that first chart, however, that the dollar was on its way down before that, a slump that started in early July and continued through the Fed’s first reduction in interest rates. Such dynamics aren’t surprising as the Fed goes into easing mode, and we see these conditions offering a potential boost to emerging markets stocks, which have tended to outperform when the dollar is weakening (see below).

Fed cut gives EM banks room to ease
Part of the reason is that emerging markets tend to be highly dependent for their growth on foreign capital, requiring EM central banks to keep up with the Fed when it’s holding rates high. As it became clear earlier this year that the Fed was on the verge of a pivot, a number of EM central banks began ‘front-running’ the Fed, easing themselves. With the US central bank making such a decisive move in September, we imagine its EM counterparts will be emboldened to continue their own expansionary policies, which should be great for their domestic stock markets.

China recovery a win for EM ex-China
In fact, it’s our bet that the Fed’s September rate cut helped China in the timing of its own positively surprising monetary policy announcements in recent days, which came quick on the heels of the Fed’s action. To the extent China’s recovery plays out the way we suggested last week that it might, that also bodes extremely well for emerging markets ex China, as those other emerging markets do a lot of trade with China—everything from chips in Taiwan to oil from Saudi Arabia and metals from Brazil—and will benefit if Chinese consumer demand recovers.

US soft landing would also boost EM
The same goes for a soft landing in the US, of course, in the sense that Fed easing not accompanied by a recession would be about as positive as one might imagine for emerging markets (a) selling lots of goods to developed economies like the US or Europe, but also (b) counting on US rate cuts to pave the way for their own growth-oriented monetary policy, and (c) looking forward to the tailwind of a weakening dollar. For all these reasons—not to mention relatively lofty DM equity valuations—we are increasingly bullish on the prospects of EM outperformance.