Market Overview
A month to forget, across global markets. Gold, commodities, foreign exchange, stocks, bonds, property and infrastructure assets all trading lower. Perhaps emboldened by their success in Venezuela, the US attempted regime change in Iran, as part of a joint operation with Israel aimed at degrading the Iranian military capacity, and particularly their nuclear ambitions.
Iran, with a population of ~90m, reflects a similar seeming outcome to Russia in Ukraine. It is very, very hard to topple, and effectively subdue a large, armed population that is unwilling to back down. Only weeks earlier, mass protests against the regime seem to have either been extinguished, or are just less visible, but either way, reduces the likelihood of change from within, and since change from within seems at a stalemate, the US finds itself in a quagmire.
For many years, the “grand daddy” of Middle East fears (from a US trade perspective) had been the potential closure of the Strait of Hormuz, a narrow body of water between Oman on one side, and Iran on the other. At its narrowest, this is a few dozen miles wide, and in a world of unmanned arial drones, and cheap rockets (to a lesser extent, cheapish missiles and mines) it is effectively impossible to guarantee the safety of vessels (VLCCs, very large crude containerships) from transiting the region.
UK insurance companies (think Lloyd’s of London) became unwilling to underwrite such maritime activities (for good reason, as several ships have been attacked) and as such roughly 20 million barrels of oil, per day, are now longer flowing through the region. This has flow on effects for refined products (think jet fuel, diesel), and also flow on effects for LNG (gas), petrochemicals, agriculture (fertilisers, phosphate etc) and so on.
Global shares
Helium, a commodity that doesn’t get much airplay, was also affected. As an input to making semiconductors, alongside fears that without LNG to power datacentres, chip and memory stocks fell throughout the month. For markets like South Korea, who had hitherto fore been enjoying a powerful rally, being heavily exposed to such stocks proved brutal, falling by double digits over the month.
Australian shares
Australia, as a key commodity exporter, and a very large producer of LNG, enjoyed pockets of strength as energy producers rallied on the supply dislocation story while Materials were mixed and dominated by the mega caps of BHP which fell while RIO was flat. Although thermal coal is a substitute for the lost hydrocarbons through the Strait, it remains the case that to get coal (or really any Australian commodity) from pit to port requires a mining fleet that runs predominantly on diesel. No diesel, no output. Australia is a rich country, and so it can “outbid” to secure diesel supply, but it was a fear that nonetheless caused fairly dramatic fluctuations across the materials sector.
Oil and the Middle East
As a thought experiment, consider that roughly 100 million barrels of oil equivalent are produced and consumed every day. The Strait of Hormuz carries roughly 20 million barrels. This has dropped by roughly 90% or more, down to near enough zero.
The chart/graphic below estimates how the 20m barrel shortfall could be addressed. The Saudi’s can redirect flow via pipelines and there are other sources of oil (oil stored in floating production infrastructure, strategic petroleum reserves (SPRs)) that in a time of crisis, can be brought into play.
The estimate is that the net effect of displaced oil is roughly 11m barrels per day (~10% of global supply). Therefore, we need a 10% drop in global demand to equilibrate/balance. That means higher prices, and historical economic estimates put the price elasticity of (oil) demand at around 0.15-0.2x. That is a low number (termed inelastic), which means that when oil prices rise, demand doesn’t change very much. E.g. you still need to fill up the car to go to work, even if the price rises. Hence very large changes in price are required to produce even modest changes in demand.
So, if we need to reduce oil demand by 10%, that will mean a roughly 5 to 6x multiple in price, in other words 50-70%. The prewar “undisturbed” price of oil was around $60-70bbl, and thus moving into the low $100s (say $100-$115) would be about what we’d expect based on these very simple “rules of thumb”.
Given the oil intensity of GDP has declined over the years, this seems like a manageable dislocation. Equities are right to reprice lower, but provided the war ends “soon enough”, as things stand, the odds of a recession are probably only around 30% (double the average, but not at breaking point yet).
Investment Outlook
Bonds have sold off as higher inflation expectations have been priced in. You can see yields rising below, and credit spreads widening too as equities sell off. We think bond yields are “capped” in the sense that if the oil supply shock lingers long enough it becomes a demand shock, which lowers expected inflation and growth, which should drive yields lower – so we are very comfortable retaining fixed income holdings. Note below (TIPS are treasury inflation protected securities, HY is high yield (riskier credit/bonds) and TWD is the trade weighted US dollar).
Like last year’s “Liberation Day,” tariffs, the current financial market damage appears largely self-inflicted. Oil supply remains essential, making the present situation unsustainable. As a result, we expect Trump to seek an off-ramp and move toward de-escalation in the near term.
Our “all-weather” portfolios remain well positioned for this environment, and we see no compelling reason to rotate out of defensives or aggressively “buy the dip” at this stage.
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