Market Perspective: Running in Place

“Life is 10% what happens to you and 90% how you react to it.”
― Charles R. Swindoll

Running to nowhere?

The last 18 months have been anything but boring, but if you had ignored the market over that time and only recently started paying attention, you may think that little has happened. The running in place analogy is probably better replaced by hiking a mountain. Lots of work involved, many ups and downs, but ultimately—you end up right back at your car where you started.

Lots of movement but little headway

We are in midyear outlook season, with Kathy Jones’ fixed income outlook, Liz Ann Sonders’ U.S. market/economic outlook and Brad Sorensen’s U.S. sector outlook already published. Jeff Kleintop’s global market/economic outlook will be published next week. In the interest of not overloading your reading list, this week’s SMP is going to be brief.

Trade and Fed policy continue to be critical to the outlook for stocks. A comprehensive trade deal is unlikely in the near-term, notwithstanding the planned meeting between Presidents Trump and Xi at the upcoming G20 meeting. The hope is that the meeting leads to the resumption of serious negotiations between the two sides. In addition, we’ve seen that new trade uncertainties can flare up at a moment’s notice; including with Mexico, Canada India, and the Eurozone. To date, the effects have been relatively muted, although the upcoming earnings season will likely tell a more complete story. Corporate confidence is mixed—larger company weaker, smaller company stronger—but consumer confidence remains strong, keeping consumer spending humming.

Corporate confidence is mixed

Although the consumer seems little impacted by trade

If the trade stalemate lingers and/or the next round of tariffs on Chinese imports kicks in, the damage to the economy is likely to escalate. The Fed addressed its concerns about trade and its impact on both the global and U.S. economies; but the burning question remains about the sufficiency of monetary policy ammunition as an offset to weak growth. The month-long inversion of the yield curve has been adding to that angst.

U.S. stocks are hovering around all-time highs, kept afloat by hopes that the Fed will begin cutting rates as soon as the July Federal Open Market Committee (FOMC) meeting. But are rate cuts sufficient to help what is ailing the economy? Absent a comprehensive trade deal, it’s difficult to imagine that executives will be confident enough to expand capital spending, which had been one of the primary rationales for 2018’s corporate tax cut. In addition, Wall Street’s analysts have yet to reflect the recent escalation in the trade war in their estimates for corporate earnings. Given that consensus estimates are already near-zero for the next two quarters (Refinitiv), an additional haircut to those expectations could mean an earnings recession.

What might a U.S. military strike on Iran mean for markets?

Geopolitical tensions always have the potential to be a wild card in the investing deck, with today’s card being heightened potential for military conflict between the United States and Iran. Although it may pose another threat to an already-vulnerable global economy, markets’ past negative responses to U.S. military strikes have tended to be short in duration.

Over the past 12 months, Iranian oil exports have fallen by 90% due to the re-imposition of U.S. sanctions; much of that coming in the past two months. In early May, the United States declined to extend embargo waivers to Iran’s remaining oil customers. We noted at that time that this heavy blow to the Iranian economy, coupled with increasing frustration with the status of the nuclear agreement, may lead to actions by Iranian-backed forces; heightening the potential for military conflict. Since then, Iran appears to have been responsible for two attacks targeting oil tankers near the world's most critical oil shipping chokepoint, the Strait of Hormuz; as well as the shooting down of a U.S. drone. The United States announced earlier this week that it would send 1,000 additional troops and other military resources to the Middle East.

Iran’s oil exports fall 90%

Source: Charles Schwab, Bloomberg data as of 6/18/2019.

Within the next month, Iran will likely exceed the caps on uranium enrichment set out in the 2015 nuclear agreement and may restart parts of its nuclear program (The Wall Street Journal). These actions could prompt a military strike by the United States. Limited U.S. strikes on Iran’s naval assets could hinder Iran's ability to disrupt traffic through the Strait of Hormuz. The U.S. Navy has moved a carrier strike group to the area.

As worrisome as these developments are to a vulnerable global economy—not to mention the human toll that may result—the market impact may be modest. Global stock markets’ past response to U.S. military strikes has been negative, but short in duration. There is a long history of U.S. missile strikes outside of declared war in the past 30 years which we can use to assess the potential market impact of these types of geopolitical events.

Markets and U.S. missile strikes*

*excluding U.S. wars: 1991 Gulf War; 2003 Iraq War; War in Afghanistan
**MSCI AC World Index
VIX denotes the S&P 500 CBOE Volatility Index. Past performance is no guarantee of future results.
Source: Charles Schwab, Factset data as of 6/16/2019.

The global stock market reaction was mixed—roughly half of the days after the event seeing losses but the other half flat or showing gains—not a pattern we can take much stock in. Larger losses of around 5% took place when the strikes occurred during the Asian financial crisis in 1998 and the global financial crisis in 2008. Oil prices and the U.S. stock market volatility index tended to rise; while gold futures, the U.S. dollar and bond yields were little changed.

Hopefully, a military escalation will be avoided. But, should one occur, the market reaction may be short and brief. When grim headlines are in the news, investors are best served by remembering that geopolitical risks are a regular part of investing, and that a long history of geopolitical developments shows us that holding a well-diversified portfolio may buffer the short-term market moves that are most often the result. Investors should avoid overreacting to geopolitical developments and stick to their long-term financial plans.

So what?

U.S. stocks have made little headway over the past 18 months; and with indexes around the highs of the recent range, another pullback is possible. Continued trade uncertainty and the potential for a limited Fed response could weigh on stocks in the near term; while an easing of trade tensions could keep the rally alive. We continue to recommend investors stay at their long-term strategic equity allocation with an eye on diversification, and using volatility to rebalance as needed.