Potential Effects of Another Conflict in a Seasonally Positive Period

Potential Effects of Another Conflict in a Seasonally Positive Period

October 18, 2023

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As I reflect on the past week's activity, top of mind is the widening Israel-Gaza conflict. In my view, this tragedy touches every investor personally. For many, this is because of personal knowledge of someone impacted. My son has a player from his water polo team from Cal Berkeley. He and his family are in a shelter in Tel Aviv. This personal connection also means markets will reflect this human aspect, particularly as the conflict is ongoing and threatens to become larger. It is logical to suggest equity markets should remain on the defensive to some extent as there are numerous ways that this conflict could spiral into more of a global situation given what we have been dealing with in the Ukraine situation already. But to think that this is something that is going to end abruptly, I believe that this would be a low probability as well. Currently, these are the issues we have been dealing with since 2022. I’ve made a note as to the announcement of a major issue and you can see how the markets have reacted:

Important information for this week & expected macro data:
– 21 Fed speakers this week, including Fed Chair Powell speaking at the Economic Club of New York, Thursday. 
– 3Q EPS season gets underway after strong earnings Friday from the major money center banks, and we see this as “better than expected” = good.
– Economic data; Sept retail sales (10/17), Sept Housing starts and Existing home sales (10/18 and 10/19).

I realize there are real-life and meaningful issues on hand, but my main focus remains on how the markets will likely react to incoming data, while taking into account the geopolitical turmoil. So please be mindful that news media might be a distraction from some incoming data points that will impact interest rates and marginally impact Fed policy. The impact on Fed policy is extremely important as the course of interest rates have had a strong effect on the equity markets. 

One might be inclined to view equities as having downside risk because of the widening conflict in the Middle East, coupled with the ongoing Russia-Ukraine War, and the political circus in DC (gov’t shutdown, new House speaker). Equity markets have reacted fairly muted to the conflict so far, as evidenced by the fact that equities managed to gain in the past week. I wanted to share a chart of all wars going back to the year 1400. Since 1400 there have only been seven years when there was not a war going on somewhere in the world. I bring this up for illustration only as the calamity and human suffrage should not be discounted ever. 

The next point that I wanted to bring up is about how incredibly negative most measures are on institutional money flows. For the last eight weeks the stock markets of the world have been on the defensive. I have made an attempt to share this throughout this period along with some level of measures on time and change from a historical perspective. As I have made clear, late July through the beginning of October tends to be a difficult period for the markets. Many investors (retail and institutional) have remained neutral and even taken on rather large short positions- particularly in the case of institutional traders. Goldman Sachs Tactical Team noted last week that their CTA model shows, S&P positioning is now max short as CTAs are short -$47bn in US equities and short-$93B globally. According to their model, if the tide were to turn from something like the Middle East settling down or good third quarter earnings, this could possibly generate $293 billion of buying of global equities. This is a sizable reversal!

Q3 earnings season started last week, and estimates have been steadily increasing. To the surprise of many (who are primarily motivated by mortgage rates) to an extent, profits are somewhat less sensitive to higher rates (via cost of debt), since so many companies are either cash rich, or they took advantage of low interest rates and refinanced their debt at the attractive low rates we saw. I bring this up as it is very important to separate what a home buyer is paying as compared to what corporate America is often dealing with. 

As for Fedspeak, JPMorgan Economists showed that Fed speak has turned less hawkish in the past week. There are 21 scheduled FOMC appearances this week, with the most closely watched being Fed Chair Powell on Thu 10/19 at the Economic Club of NY. The expectation is that he will hint at a pause and, similar to other Fed speakers in the past few weeks, seems less hawkish than in late September. Besides the Fed speakers and the Chairman becoming less inclined to raise rates again, the new, international conflict also tends to act as a rate stabilizer and often a reason for the Fed to lower rates. I don't believe this will be the case unless this conflict escalates to a global issue, but history has shown that the Fed tends to want to raise liquidity in the situation of a conflict. Bottom line: Watch the 10-year yield, but we believe upside impulses have faded.

Overall, we understand investors want to be wary given the more uncertain geopolitical environment. But we think equities will take their cues from 3 sources:

  • The direction of yields—and it seems like the US 10-year yield is drifting lower. Lower is constructive for stocks.
  • The expectations for a hike by December—Fed funds futures show this probability is still around 30% and we expect this to fall to zero as incoming data comes in. While many fear a resurgence of inflation, Fedspeak shows that the rise in longer term yields is accomplishing the tightening the Fed wants.
  • Expect positive 3Q23 EPS—earnings this season could trigger / catalyze the upside momentum in equities. As the Goldman Sachs CTA study that I mentioned above points out, there is an overabundance of dry powder and a new reason for upside could bring out buyers and fast acting institutions covering their shorts.

In closing, I thought I would show Ari's updated Presidential Election Cycle. It goes back for quite some time and covers the past 10 elections. I find it uncanny how this year's markets have had such a high level of correlation with this historical cycle action:

Seasonality suggests that stocks should be starting to rally right about now. The S&P 500’s strongest period begins on the 197th trading day of the year- October 13th (in 2023) and extends through year-end, notes Jay Kaeppel, senior research analyst at Sentiment-Trader. If this is an indication of what is to come, then the conflict in Israel will be to a certain extent ignored by the markets and to the surprise of many, the year-end rally could commence. This week is full of economic reports and comments on interest rates from our Fed officials. Stay tuned!


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