Geopolitics Is Dimming The Outlook

Week Ending 27 October, 2023

Israel-Gaza update. The Israeli army remains amassed on Gaza’s border while diplomatic attempts continue over the hostages. Additionally, European efforts are aimed at crafting humanitarian corridors for supplies to get into Gaza. The latest Israel-Hamas situation has resulted in at least 19 attacks on US and coalition troops in Iraq and Syria by Iran-backed forces resulting in the US military conducting strikes against two facilities in eastern Syria used by Iran’s Islamic Revolutionary Guard Corps. It is this kind of escalation that is resulting in growing concern about the current Israel-Hamas conflict spreading across the wider Middle East. Drones and cruise missiles have been fired by Iranian-backed Houthis on a US warship. The US has some considerable, military presence in the region – yet none of this seems to be deterring attacks by rebels that are supposedly Iranian-backed.

Some possible signs of encouragement:

1. The US and allies are worried all this could spread. There are growing calls from both within and outside Israel to rethink its strategy for a full-blown ground invasion. With Hezbollah to the north and Hamas to the south, these two groups alone could drag Israeli forces into a long, drawn-out guerilla warfare. Israel knows this – the one thing it will not be able to avoid is a high death toll. To cap it all, look how the US has been rattled with so many attacks as referred earlier. The last thing we need is for Iran to get involved.
2. France’s President Macron landed on Tuesday to try and push for a resumption of Israeli-Palestinian peace talks, the creation of a Palestinian state (which was always the intention following the UN 1948 carve-up) and a halt to Jewish settlement building – a tough ask at such a moment!
3. Negotiations around the hostages (some 200) continues and we have seen some being released. It has been an opportunity for some countries (like Qatar) to take credit and be seen as a peace-maker. Qatar has invested heavily in infrastructure in Gaza.
4. Having initially bounced immediately following 7th October, Netanyahu’s approval rating has since slumped. The Jerusalem Post reported a 22% approval rating (28% in June). Any aspirations Netanyahu and others may have had to capitalise on his initial boost in the polls has truly evaporated! Senior officers, of the IDF, have an approval rating of just 45% although faith in the IDF remains a stellar 87%. 49.5% of Israelis believe Israel should negotiate with Hamas to release the hostages – even if it means stopping the war (17.5%) or while continuing the war (32%). I am not sure how one can support a war while still wanting a negotiation!!?? 43% of Israelis believe the IDF should wage war against Hezbollah now while 41.5% believe the army should do its best to prevent going to war in the north. The point here is all this starts to narrow Israel’s options It might instead be limited to targeted military action while keeping Gaza “locked up” (water, food, internet, etc.) and reliant on aid.

Market update:….and markets?

We have seen a softening in activity indicators per the release of PMI data but this is also at odds with sentiment data. While geopolitics is dimming the outlook, equity risk premium is not showing signs of increasing – in fact, it continues to fall. The release of US Q3 GDP had results which were better than expected. It grew at a faster-than-expected 4.9% y/y. Contributions came all round – consumer spending, increased inventories, exports, residential investment and government spending. The four, previous Quarters ranged between 2.7% (Q3 2022) to 2.1% (Q2 2023). Consumer spending rose +4.0% (+0.8% in Q2). Inventories contributed +1.3% (suggesting they are finally picking up as stocks get low). Private Domestic Investment soared +8.4% while Government spending & Investment jumped +4.6%. Consumer spending was quite even between Goods and Services. Furthermore, Japanese inflation came higher than forecast, Vietnam is seeing a jump in Foreign Direct Investment, China’s corporate profits showed a marked improvement q/q (still down y/y but much less so vs the previous quarter) and Spain’s GDP was better than expected. So we have a tale of two stories – economically, it’s definitely picking up while geopolitically, we are on the edge.

Therefore, not surprisingly, bond market yields shot up…and that has been weighing on markets heavily. Equities remain under downward pressure - yet equity risk premium continues to fall (see chart below). Japan has ticked up because of its domestic inflation scare boosted by Yen weakness. Investors (foreign and domestic) are going into local stock markets there because domestic yields simply don’t cut it for them with inflation running some 2X to 3X higher than Bond yields.

When it comes to bonds, we saw the US 10y Treasury yields hit 5%. Various models have shown there has been a large increase in the bond risk premium in the long-end section of the Yield Curve. A GS study showed that a 100 bps (=1%) rise in the term premium – which is roughly what we have witnessed so far – equates to a 0.20% to 0.60% boost to the US 10y excess return across 1y to 5y holding periods. In a nutshell, the risk-reward looks good – even more so if you can hold on for a 3+ year time horizon. This analysis assumes all else remains steady! There are several variables at work here: consumer demand (latest GDP data was underpinned by very strong consumer spending), wages (recent Union strikes and threats of strikes have resulted in wage hikes far above the national trends) and energy prices (keep a close eye on geopolitics).

As of 20th October, the yield on High Yield corporate bonds peaked at 9.3% (Feb: 7.6%). The cost of insuring exposure to European junk debt also hit a high as of the same date to 473 bps over US treasuries. The next market/systematic fallout will come when companies have to refinance their debt at a higher funding cost. Defaults are rising reaching 118 this year (double that of 2022). However, these are still low to what usually plays out. We haven’t had an exogenous shock to corporate cash flow – that can only happen (all else equal) when debt has to be refinanced at current, vastly higher rates. Meanwhile, as it stands, the US will need to refinance some 50% of its total Federal debt in the next three years.

MARKET SUMMARY