Some Final Words on the Market Outlook

This is my last strategy publication before my retirement at the end of March and I would like to conclude with some final words on the intermediate-term outlook for stocks. (I will be publishing a final technical analysis review tomorrow).

Let’s begin with the good news. My long-term timing model is still bullish on the U.S. stock market. As a reminder, this model flashes a buy signal whenever the monthly MACD of the broadly based NYSE Composite (bottom panel).
 

 

Ozan Tarman, vice chair of global macro at Deutsche Bank, revealed in a Bloomberg podcast that in speaking to global macro hedge funds, he concluded that the pain trade is a squeeze higher, though the left-tail of the return distribution is quite fat.
 

 

A Gulf War III Scenario
No analysis of the intermediate-term market outlook is complete without a discussion of the resolution of Gulf War III. I listened to a lot of podcasts so that you don’t have to. Here is some of the more important points from a number of different podcasts.

A Bloomberg podcast with Rory Johnston outlines the stakes. On a normal pre-war day, about 20 million barrels of oil transit the Strait of Hormuz (SoH), representing about 20% oof global demand. At the height of the COVID pandemic, global oil demand fell by 20%. In other words, a full closure of the SoH forces the global economy into a demand shrinkage equivalent to the height of the COVID shock. Johnston reckoned that oil prices need to rise to over $200 in order for such a scenario to transpire.

That said, there are some ways to mitigate the loss of SoH flows. Iran is still producing two million barrels a day that is transiting the Strait. Saudi Arabia has an east-west pipeline that bypasses the Strait, and the UAE has a pipeline that ends just outside of the Strait. According to the accompanying chart produced by Johnston, this still leaves a shortfall of 13 million barrels. Some of the shortfall can be mitigated by buffers, such as the oil that’s already on the water and the release of strategic petroleum reserves, which amounts to about three million barrels a day. The global markets and economy will need to address the remaining shortfall by adjusting prices.

 

In reality, Johnston’s flow estimates slightly overestimate the shortfall. The Saudi East-West pipeline capacity is five million barrels, which he penciled as four in his chart. Reports of recent throughput have been as much as seven, but it’s an open question whether these flow rates are sustainable. As well, Iran has been allowing a limited number of tankers with loads not connected with the U.S. and Israel to pass – for a fee. These additional mitigation measures potentially half Johnston’s daily shortfall of 6.17 barrels a day.

A separate Geopolitics Decanted podcast with retired Rear Admiral Mark Montgomery, who was the Director of Operations at the U.S. Navy’s Pacific Command. Montgomery served with Admiral Brad Cooper, the current head of CENTCOM, and knows Cooper well.

From a tactical perspective, tankers transiting the SoH face a multitude of threats, such as speedboats, anti-ship cruise missiles, missiles, drones and mines. The U.S. is deploying patrols of A-10 attack aircraft and helicopters to hunt down potential threats. Montgomery postulates a campaign to degrade these threats. The threat will never be fully eliminated, but reduced to an acceptable minimal level so that the U.S. Navy can conduct convoys. Montgomery estimates they are at least a week away from that point, when the Navy can pivot from attack to stabilization.

Montgomery went on to detail how a convoy might work. Deploy two or three Aegis-class destroyers, which have an array of radar systems to detect possible threats, to screen the convoy of ships transiting the SoH. Typically, a destroyer might have about a 60-second reaction time to detect and shoot down incoming missiles and drones. That’s why the initial degradation phase is important. The destroyers and aircraft can deal with one or two missiles, but would be overwhelmed by a swarm of 6–10 missiles. The current phase of degradation is designed to minimize the launch threat to an acceptably low level.

Based on what Montgomery said, the U.S. could transition in early or mid-April from a bombing to a stabilization phase of the campaign. It would deploy destroyers for convoy escort duty. If we use Montgomery’s timeline as my base-case scenario, Trump could realistically declare “victory” by early April and announce a naval escort program for tankers and other cargo ships.

Addressing the issue of strategic goals, Montgomery reframed the U.S. strategy as not so much regime change, but to handcuff the Iranian regime’s ability to threaten its Gulf neighbours, Israel, and the U.S. by degrading its ballistic missile program and defensive industrial capability, sink its navy, and constrain its nuclear development program. Those goals have mainly been met. He estimates the Iranian missile program has been set back five years, navy about seven years, air defense three to five years, and drone program only a year. The nuclear program is the most difficult to measure. It creates sufficient breathing room for Iran’s neighbours to create a framework to contain Iranian ambitions.

In addition, the Trump-Xi summit has been rescheduled for May 14–15, which is an indication that the White House expects combat stabilization by mid-May. While all this may sound like good news for the markets, the costs of the war would start to appear in the global economy. The closure of the SoH didn’t just cut off oil, but triggered a global supply shock with “disruption [that] extends well beyond energy, cascading through chemicals and fertilizers into food systems, with the most severe consequences falling on developing economies”, according to the Kiel Institute.

As an example, the last load of LNG that left the Gulf should be arriving in Asia during the last week of March. The full effect of the supply shock will start to be felt in Asia in April, and the shock wave will traverse to Europe and the Americas.

The Kiel Institute modeled the wide ranging effects of this supply chain disruption:

The consequences extend far beyond the energy sector. Energy prices rise most sharply — but the critical finding is how these increases propagate: natural gas is the primary feedstock for nitrogen fertilizers, and Gulf chemical exports underpin agricultural supply chains worldwide. When energy supply is disrupted, the effects cascade through chemical production into agriculture. Global energy prices rise by +5.4%, but food prices follow at +2.9% — well beyond what standard trade models would predict.

 

 

The key question for investors is whether the market will welcome the announcement of an end to major hostilities or become rattled at the economic effects of a supply chain shock that’s already been set into motion but may not be fully discounted. An article in the Economist outlined the difficulties of restarting oil and gas production and concluded that “Even if Donald Trump and Iran reached a deal to stop fighting tomorrow, it would thus be another four months before markets regained some semblance of normality.”
 

Tactically, the stock market’s recent recovery is an indication it is being led by cyclical industries. This is an indication that it’s prepared to look through the valley of a multi-month slowdown and supply chain difficulty.
 

 

Can the cyclical leadership continue? Risk-on or risk-off?
 

 

The Bullish View
A YouTube interview of Robin Brooks by Paul Krugman produced a more sanguine view of the effects of the war.

Brooks believes that calls for Brent oil to rise to $150 and beyond are unrealistic for two reasons. Brooks cited a back-of-the-envelope calculation from the Russian invasion of Ukraine in 2022. Russia exports about seven million barrels of day of oil production, and it was initially feared that those barrels would be sanctioned, and oil prices rose about 20% in reaction. By contrast, 20 million barrels pass through the SoH, so the ratio of Russian oil to SoH oil is about three. Brent crude rose about 60% at its peak in reaction to the latest conflict, which is also a 3-to-1 ratio to the 2022 Brent price surge. To be sure, there is a disparity between the pricing of crude from the Gulf compared to Brent, which is an Atlantic-based benchmark. Nevertheless, Brooks concluded by that metric the market has fully priced in the potential disruption from Gulf War III.

Brooks also projected the price of oil based on oil demand elasticity. For non-economists, demand elasticity measures how much the oil price needs to rise if output were to decline by
-1%. The figure is low in the short run because it’s difficult to reduce energy demand, but elasticity is notoriously difficult to estimate. If you use a demand elasticity of 0.15, which is in the middle of the range, you get an oil price of 60–70%, which is roughly in the ballpark of the current price surge episode. The price projections of $200 and beyond from the likes of Rory Johnston would require a much lower elasticity estimate.
 

 

That’s the good news on oil prices. Fears of an energy-driven Apocalypse are overdone.
Brooks went on to outline the evolution of the market during the 2022 Russian invasion of Ukraine. The initial reaction was a rush into USD assets. When the war drums began to beat in early February, the USD rose and Treasuries began to outperform foreign-developed market sovereign bonds on a duration-equivalent basis. When the shooting began, non-U.S. stocks skidded against the S&P 500, though relative performance has stabilized since.
 

 

That’s where we stand today. The next step is the outperformance of commodity exporting countries like Brazil. Regardless of how the war is resolved, the key lesson that the world will have learned is the fragility of supply chains, much like the lessons of the COVID pandemic. Every commodity will be re-evaluated as a “critical mineral or molecule”. Strategic reserves will be established. Watch for capital expenditure stampedes in the sector.
 

 

Portfolio Positioning
I have shown the accompanying chart of the upside breakouts of the gold to S&P 500 ratio and the gold to 60/40 portfolio ratio in the past. The breakouts are the signs of a hard asset cycle. A 60/40 allocation will lag under such conditions and investors should consider a greater allocation to commodities or commodity-sensitive equities in lieu of their bond allocation, such as 60 stocks/20 bonds/20 commodities.
Tactically, precious metals are extended and are undergoing a period of correction and consolidation. Investors should take advantage of this opportunity to deploy more funds into inflation hedge vehicles.
 

 

As for the equity portion of the portfolio, we continue to believe in the barbell approach of allocating to U.S. large-cap growth and non-U.S. value stocks.
 

 

While doubts have begun to arise about Magnificent Seven leadership and U.S. large-cap growth has lagged the market recently, U.S. technology insiders are still buying their own shares into weakness.
 

 

 

Key Risk
To be sure, my portfolio positioning is based on a relatively orderly wind-up of the war. The key risk to my forecast is a disorderly escalation that raises the risk of more supply chain disruptions and a global recession. Conceivably, the U.S. could insert a significant contingent of ground troops, but the operation doesn’t go as hoped, and we see greater force commitment and mission creep. The WSJ reported that the Iranian-backed Iraqi militia has adopted Russian drone tactics to which American forces have little or no defense, which could render a ground invasion a military disaster. Iran could retaliate by attacking Gulf energy production and export infrastructure. Worse still, Iran could attack the Gulf’s desalination capacity. Iran has minimal exposure to desalination for its water, Gulf country dependency ranges from 40% to 90%.
 

 

In conclusion, my base-case outlook for equities is bullish, based on my base-case scenario of an orderly wind-up of the war. Long-term investors should focus on a barbell portfolio of U.S. large-cap growth and non-U.S. value for the equity portion of their portfolio, and make a greater allocation to commodities in the normal bond part of the portfolio. The key risk is the Gulf conflict spirals out of control and raises the risk of a global recession.