by Jurrien Timmer, Director of Global Macro, Fidelity Management & Research Company
With the conflict in Iran becoming seemingly more contracted, the markets seem to be pricing in a less benign outcome despite what has been a Goldilocks backdrop of robust earnings growth, rising margins and productivity, hefty capex spending, an easing Fed, and a well-behaved bond market. That 1970’s word “stagflation” is now creeping back into the headlines. For now, the stock market seems to be pricing in a relatively quick conflict, not unlike the 1990 Gulf War, but who knows? Fortunately, we haven’t had that AI bubble that many were expecting just a few months ago, and that appears to have left markets less over their skis than what might have been. Still, the convergence trade between US and ex-US equities and between the Mag7 and the broader market got perhaps a bit crowded, so it may take a bit for the recent leadership to resume. When the dust settles, I expect those themes to resume.
Futures are red
Oil prices are spiking as the frozen Straits of Hormuz has become the epicenter of the conflict. As of Sunday night’s futures open, WTI futures are trading at $108, which could make the equity drawdowns below old news by the time Monday arrives. As of Friday, the S&P 500 was down a modest 4.2%, but the MSCI EAFE and EM indices were down 7.8% and 10.2%, respectively.
Energy & credit
The following chart shows the stress points affecting the markets. Above the dotted line are the VIX, crude, bond volatility (MOVE), and credit spreads. Below the dotted line are the drawdowns in the various public companies that specialize in private credit.
A history of oil spikes
Taking a look back to the 1930’s, we can see the various oil spikes over time. The top panel shows the 5-year CAPE ratio, and the bottom panel shows nominal oil prices in brown, and inflation-adjusted oil prices in purple (indexed to today’s CPI). There was the one-two punch of the 1973 and 1979 oil shocks (Yom Kippur War and Iranian Revolution). Those shocks drove equity valuations down significantly (from 21.2x to 9.8x and then from 11.8x to 7.6x), although there were other factors at play as well (including entrenched inflation and a form of fiscal dominance). Then there was the Gulf War in 1990, which produced only a short-lived spike to $100 in today’s dollars (and pushing the 5yr CAPE down 4 points from 18.4x to 14.0x). During the 2000’s there was the Peak Oil theme leading up to the GFC in 2008. That bubble burst because of demand destruction from the GFC as well as the shale revolution. The 5y CAPE ratio fell from 22.9x to 8.5x, but for many reasons other than oil prices. More recently there was the Russia/Ukraine war in 2022. That was also the “rate reset” bear market, which pushed equity valuations down from 31.9x to 21.4x.
Rates & the Fed
Fortunately the US consumer has become much less sensitive to oil prices since the 1970’s, but the impact on inflation could keep the Fed from easing rates further despite the soft labor data. As a result, the 10-year is creeping higher and the forward curve has already unpriced one rate cut. That contracting triangle for the 10-tear Treasury yield has been very persistent!
Heat maps
In order to help us visualize the various stress points in the market (and in case they get worse), I created several dashboards over the weekend.
First up is the commodity & currency heat map. From left to right are the last 13 weeks of data, followed by the 5 year max and min. The 5-year history includes the oil spike in 2022, which is why the various vol measures don’t show up as more extreme right now.
Here is the rate/Fed and credit heat map.
And here is my dashboard for equities. Nothing too extreme yet in terms of breadth, drawdowns, and sentiment, but that could change of course. With the 4% drawdown in the S&P 500, the market is now at fair value based on my DCF model that normalized the ERP for credit spreads and margins.
Line in the sand
If the markdowns continue for equities, then the Mag7 will likely break support (below). That could be enough to turn what so far has been a 4% SPX drawdown into a more bona fide 10% correction.
We can see from the equal-weighted S&P 500 index below that the convergence trades within the US markets as well as between the US and non-US markets are being unwound to some degree. When the tree is shaken, the hot money retreats as it is doing now.
Correlations tend to go to 1 when the markets are under stress, and that’s what happening following a period of shrinking correlations. I remain bullish on these convergence trades, but we will need to wait for signs that the excesses have been washed away.
Correlations
Looking at correlations another way, the chart below shows the evolving 5-year correlation of selected asset classes against both the S&P 500 (vertical) and the BBG LT Treasury index (horizontal). You can see how equities have become slightly more correlated to bonds, but less so for EM and EAFE. The true diversifiers remain alts (managed futures in the blue), and commodities (BCOM in the dark blue, gold in gold, and Bitcoin in orange).
60/20/20
It has been my thesis for the past 5 years that the “new” 60/40 is more like a 60/20/20. To illustrate this the chart below shows that a hypothetical 60/20/20 portfolio, allocated as noted in the chart, could have sharply outperformed the standard 60/40 index recently, mostly due to gold and non-US equities. The table is definitely not investment advice but just my personal take on what a truly diversified portfolio might look like.
Bitcoin
Bitcoin has continued to search for a bottom, and I still think that the $60k is a good place to look. We may well undercut it at some point, but based on the power law support line and the gold/Bitcoin ratio, I believe that level should act as a floor.
This information is provided for educational purposes only and is not a recommendation or an offer or solicitation to buy or sell any security or for any investment advisory service. The views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Opinions discussed are those of the individual contributor, are subject to change, and do not necessarily represent the views of Fidelity. Fidelity does not assume any duty to update any of the information.
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