Few investors expected war to break out in Israel, but stocks still eked out a gain on the week. As devastating as the events in the Middle East have been, to see stocks gain suggests they likely have bottomed and could be due for a fourth-quarter rally. Unsurprisingly, gold and oil had strong gains.
- In the face of grave headlines, stocks finished higher last week, increasing the likelihood that they bottomed in early October.
- Geopolitical events can be tragic; yet, in many cases the economy and stock markets take them in stride.
- An upside inflation surprise looked better beneath the surface, and the market response was appropriately muted.
A pullback in bond yields sparked some of the strength in stocks. Yields have soared recently, raising concerns about the impact on consumers and corporate America. Although we continue to believe yields are rising due to an improved economy, stocks will need yields to at least level off before a major rally can take place. With yields overextended, geopolitical risk was enough of a catalyst last week to push investors to buy bonds and, consequently, lower yields.
Seven of the last 17 bear markets ended in October, and many smaller market corrections have ended during the same month. As Mark Twain said, history doesn’t repeat itself, but it often rhymes. This year could see another October low, as stocks, not unusually, found support near their upward-sloping 200-day moving average.
Our Thoughts on the War
We have received several questions about the potential market impact of Hamas’ brutal terrorist attack on Israel, the Israeli response, and the ongoing aftermath. Considering these types of issues is part of our job, but we are also aware that these reflections are trivial compared to the events themselves and the lives they impact.
As discussed above, the stock market reaction thus far has been somewhat muted compared to historical geopolitical shocks, although the bond market experienced some buying pressure and oil prices rose. Markets are forward-looking and typically begin to weigh recovery even as uncertainty persists.
Similar historical events, which vary significantly in scale, shows median performance over the following year is somewhat lower than historical returns. The average return is also weaker than the median, signaling asymmetrical downside risk. But context here is very important.
Much of the negative market behavior above is unlikely to have been driven by the geopolitical shock itself. For example, the U.S.S. Cole bombing coincided with the tech bubble bursting in 2000. The coincidence of drawdowns and recessions independent of geopolitical risks stands out from the data, more so than the downside risk of geopolitical events. Most of the major drawdowns have taken place during or near a recession, including those in 1956, 1973, and 2000-2001.
But there are cases where geopolitical risk played some role in the decline. For example, Russia’s invasion of Ukraine worsened inflationary pressures, eventually contributing to an aggressive Federal Reserve and a burden on stock markets. But that has been the exception rather than the rule. Markets saw strong gains despite the Iraq invasion in 2003 and Israel’s Six-Day War in 1967. And, of course, beyond the tactical 12-month time frame, the markets have always recovered.
Despite several Middle Eastern conflicts that did not lead to market drawdowns, the Yom Kippur War in 1973 played at least some role in the ensuing market sell-off. But we believe the current circumstances are quite different. In October 1973, an Arab coalition led by Egypt and Syria launched a surprise attack against Israel on Judaism’s holiest day, Yom Kippur. After detecting Soviet resupply to Syria and Egypt in response to an effective Israeli counteroffensive, the U.S. began a massive resupply to Israel. The oil cartel OPEC responded by declaring an oil embargo against the U.S. and other countries. In 1973, the U.S. had grown increasingly dependent on foreign oil. As a result of the embargo, oil prices tripled and the added strain on the economy was one cause of the recession.
While several themes related to the current conflict are in play, times have changed significantly.
- Hamas has tried to expand the conflict by implicating Iran’s support, much as the Yom Kippur War also became a Cold War flashpoint. The claims have been treated as suspect thus far by U.S. and Israeli military intelligence, but the issue is unresolved. Nevertheless, Iran is not the Cold War Soviet Union, and Russia is depleted due to its ongoing war in Ukraine.
- While various degrees of tensions exist between Israel and its neighbors, as of now the scope of the conflict is relatively narrow, focused geographically on Gaza.
- The dependency of the U.S. on foreign oil is dramatically different than it was in 1973. In the 1970s, domestic production was increasingly unable to meet demand. Today, U.S. production alone could meet it almost entirely. In fact, the U.S. exports a little less than half its oil, making it a net oil exporter. As seen in the chart below, oil exports comprised 4% of imports in 1973. By 2022, that percentage had risen to 115%.
- Canada, not OPEC, is the largest source of foreign oil in the U.S. today, accounting for approximately four times the imports from all of OPEC.
Two risks remain:
The conflict could expand, and the Middle East remains a sensitive region. We view this as unlikely, but it remains a marginal possibility.
The largest economic vulnerability is similar to the hazards presented by the Ukraine conflict. Central banks, businesses, and consumers remain sensitive to inflation risk even as prices continue to follow a disinflationary path. As a result, broader sensitivity to higher oil prices may be more acute than usual. And even if OPEC’s role has diminished, particularly in the U.S., oil supply and demand is still a global phenomenon. However, oil prices remain below last year’s peak, and consumers have been resilient even at higher price levels. The most salient impact of oil prices on Americans is via gas prices, and prices at the pump have fallen recently despite the run-up in oil. Shrinking refining margins means pump prices are likely to fall even further. That’s a tailwind for American households and consumption.
The Carson Investment Research team has not changed its overall market outlook in response to the conflict, although we continue to monitor the situation closely. We remain overweight equities but do favor the energy sector. In addition, we continue to be cautious on rates but have recommended adding duration (interest-rate sensitivity) to bond portfolios as rates climbed sharply higher. Our recommended positioning, however, remains below the duration of the Bloomberg U.S. Aggregate Bond Index. Most importantly, we think the U.S. economy can continue to avoid a recession on the resilience of the U.S. consumer.