Having enjoyed an exceptionally-strong December month’s returns – a classic “Santa Claus rally” – investors returned to the unsettling news that on 2 January, the key military figure in the Iranian regime, General Qasem Soleimani and important Iran-linked militia leaders in Iraq has been killed by a US missile strike near Baghdad airport. This development was surprising at the time, but must be seen in the context of 2019’s intensification in tension between pro-Iranian militias in the Gulf region and western governments attempting to stabilize Iraq and keep oil channels open. Various incidents going back to the attacks on oil tankers last June and including the recent assault on the US Baghdad embassy form a continuum of escalation, which until recently investors were largely ignoring.
Given the impulsive nature of President Trump’s announcements, the current pre-impeachment Congressional manoeuvrings and the fact that 2020 is a US election year, investors naturally feared that the targeted assassination of Soleimani is a forerunner of a major renewed campaign in the Gulf. There is no doubt of considerable dissatisfaction with the state of nuclear anti-proliferation initiatives, and unresolved Syrian and Iraqi factionalism, added to which is Israel’s influence with Washington and the recent re-instalment of Benjamin Netanyahu as Israel’s hard-line Prime Minister.
So, the Middle East remains in a mess. The latest news of Iranian missiles being implicated in the destruction of the Ukrainian passenger airliner shortly after take-off from Tehran only underscores the dangers prevailing in the region and how easily rash actions can create an even worse situation and highlights the moral ambiguities of the continuing conflict.
Nevertheless, investors are learning not to overreact to news headlines. This is partly because few investors are capable of implementing the instantaneous trades required to exploit rapidly-changing price shifts. For instance, it has emerged that algorithmic trading systems automatically issued large “sell” orders on currencies and equities, having observed a spike in the worlds “Iran attack” in newswires. Later in the same trading session when the US and then Iran clarified their (current) positions, the traders reversed positions and markets rebounded rapidly. In the last two days, the US equity market has gained new all-time record highs, while the oil price has fallen by more than 5% - more than undoing its Friday-to-Monday knee-jerk price spike. The US dollar, which had been weak in December, has also rebounded somewhat, which reflects both safe-haven flows and profit-taking by traders who had been short USD
Consequences for our investment views and positions
We have flagged for several months that geopolitics is the main global risk to asset markets. With greater certainty emerging this year on both the China trade situation and on BREXIT, Gulf flare-ups and Iran / US frictions are now the key unknown factor. However, our view is that at present, headline shocks should be seen as distraction. The underlying world economy is actually moving to a slightly better phase in response to cyclical trends and last year’s additional monetary policy stimulus from Central Banks. Positive fiscal policy impacts should add to this later in 2020. Market talk of near-term recession risk, which was widespread as recently as August, has faded completely, and interest rates reductions are now more likely to be the exception around the world, with most Central Banks indicating they are “on hold.” Given still-low inflation, other things being equal, the outlook is positive for equities.
That is not to say that there are no real risks and investors should simply prepare for another bullish run. Valuations have once again become quite stretched in some equity sectors, and bonds remain very expensive given the gently-improving global economy. We have recently retained a neutral allocation to global and domestic equities for this reason, rather than re-instituting an overweight position - which would require a clear value opportunity (such as the one we took advantage of last January.) We retain a slightly above-neutral allocation to cash, and have some equity downside mitigation coverage in place for large diversified funds via the options market. In addition, the risk of sustained higher energy prices is reflected in our portfolios’ commodities allocation and were they to endure to the degree that oil was generating sustained inflation pressure, our underweight of global bonds would be expected to benefit as interest rates would then likely see some more upside movement.
Overall, we expect a guarded resumption of the positive trends that investors enjoyed in late 2019.
This blog post has been prepared to provide general information and does not constitute financial advice in accordance with the Financial Markets Conduct Act 2013. An individual investor should, before making any investment decisions, consider the information available in the relevant Product Disclosure Statement and seek professional advice. While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited and the AMP Group (together, 'AMP') make no guarantee that the information supplied is accurate, complete or timely and do not make any warranties or representations in respect of results gained from its use. The information is not intended to infer that current or past returns are indicative of future returns. The views expressed are those of the author and do not necessarily reflect those of AMP. These views are subject to change depending on market conditions and other factors.