Wait and see in light of the dramatic conflict in Israel

Alberto Matellán, chief economist at MAPFRE Inversión

In recent weeks we have seen sharper than usual market movements, particularly in bond markets, but also in other asset classes. As a result, headlines are increasingly speculating about future price fluctuations. But perhaps the reality of the situation was less sensational than it appears. However, last weekend everything changed, after the dramatic conflict that has started following the attacks in Israel.

The initial response from investors has followed the typical pattern seen in any conflict: increased risk aversion and a significant rise in commodity prices All this has led to greater volatility that could last for a few days — two weeks at most — until the market prices in the new scenario, which will depend on the anticipated intensity of the conflict, i.e., how investors expect it to develop in both time and physical space. As we await this adjustment, it is worth noting that this conflict is likely to have an inflationary impact. Wars, aside from the human tragedy they entail, typically exert upward pressure on prices. This is due to two reasons: they demand a lot of energy, and they are intense in terms of public spending. Consequently, we can anticipate additional inflation in a context where the market had already factored in a core inflation that was not moderating to the extent it initially appeared. All of these factors could contribute to steeper yield curves and pose increased threats to economic growth, further exacerbating the central banks’ already significant dilemma.

We observe the market swing back and forth like a pendulum. It initially values a specific scenario, but as time passes, various forces accumulate, driving it in a different direction. Eventually, these forces succeed in prompting investors to abandon their current position, often leading them to another extreme. But the economic reality is often more tedious and changes very slowly. That is why the sound investor does not get carried away by such swings without carefully analyzing whether there has been a fundamental change in the scenario. And, as such, managers are best advised to adopt a “wait and see” position.

For months now, there have been warnings of a divergence between central banks’ messages and investors’ beliefs based on market prices. The former insisted on the need to remain vigilant with regard to inflation, while the latter remained convinced of forthcoming rate cuts in view of the imminent slump in growth. In September, we saw the capitulation of the latter group. The activity data, though weak, do not suggest a recession so urgent as to trigger a shift in central banks’ stance; perhaps this outlook has only been delayed, but for now, the message from monetary authorities remains the same. The latter have not only not relinquished their position, but have reinforced it, backed by very high core inflation data, energy prices, and the strength of certain labor market figures. And the conflict in Israel and its possible consequences on the economy give even more weight to this group.

As a result, investors have taken on the much-vaunted message of “higher for longer.” For the sake of accuracy, it is important to clarify that “higher” does not imply substantially elevated rates when compared to the current ones. Instead, it means they are merely above what the market had expected. In simpler terms, the correct understanding indicates that this is essentially a recalibration of expectations. As a result, the increase in yields is limited in magnitude, but it might not be as constrained in terms of duration. Regardless, they have already reached levels that represent highly attractive opportunities for experienced active fixed-income managers. Not only because they may decrease in the distant future, potentially resulting in capital gains, but also because at these coupon levels, managers have significant room to achieve positive results, even if yields were to continue their upward trend.

There is a second and more profound, albeit less well-known, reason for the movement: liquidity. In the process of fighting inflation and raising rates, central banks are using another complementary tool: balance sheet reduction. In other words, they are lowering the amount of money in the market. This process reached its peak this summer, with the ECB and the Fed withdrawing on average more than $100 billion per week. Doing so helps to reduce the price of listed assets. It is noteworthy that one of the hardest-hit assets has been U.S. government bonds. However, this can be attributed to their management, particularly by the Federal Reserve. Furthermore, renewed concerns about the sustainability of the U.S. deficit and other factors, such as the structural decline in demand for the U.S. dollar, also contribute to this trend, although these matters are substantial enough to merit a separate discussion. Indeed, whether we like it or not, we are currently experiencing a liquidity reduction process, which is highly justifiable depending on the prevailing economic conditions. However, as it gains more prominence, it demands a substantial level of caution in the markets. Regrettably, it doesn't seem to be subsiding in the near future; on the contrary, it appears to be escalating. And once again its impact is magnified in the present context due to the emergence of this new conflict.

Even so, I believe that the ongoing events neither necessitate substantial portfolio realignments nor provoke major concerns. Conversely, they align the market situation more closely with the economic reality, which calls for greater caution than investors appeared to exercise just a couple of months ago.