JRE - Measuring The Market Impact Of Rising Global Risks
2023-10-17 07:30:00 ET
Summary
- What the Gaza conflict could mean for oil markets.
- Why the real threat to markets is if the Israeli-Hamas conflict pulls in other actors.
- Managing a portfolio in a time of uncertainty.
The conflict between Israel and Hamas is adding more uncertainty to markets already grappling with higher geopolitical risk and rising volatility. Michael Craig, Head of Asset Allocation at TD Asset Management, speaks with Kim Parlee about the impact of the ongoing events on financial markets.
Kim Parlee: The conflict between Israel and Hamas has been horrifying. It's also raising questions about an intensifying crisis in the region and the worsening geopolitical environment. Here to discuss the implications for the markets, Michael Craig, Head of Asset Allocation at TD Asset Management. It's always nice to have you here.
Michael Craig: Pleasure to be here, Kim.
Kim Parlee: So, you know, putting aside the humanitarian side of this, which has been horrifying, when you look at this from a market perspective, what do you see? I mean, what are you seeing happen with regards to how it impacts the markets?
Michael Craig: Well, similar to what's happening in Ukraine, you know, this is a region where you're having a lot of oil being shipped. And so oil and various types of energy does get a bit of a risk premium put to it. You'll see it in the cost of volatility or insurance on oil. You saw an initial lift in oil.
And I think oil in general will trade with a bit of a premium now because we have some degree of uncertainty now about what might transpire from here. It might be a localized war, or it might draw in other actors. And then, that way, you could actually see a real material move in oil much higher.
So I think that's the biggest issue for day one. Historically, looking at conflicts in the Middle East, you have a big outcome of returns in the markets. There's actually been periods when you've had the market rally and periods where it's actually sold off. And the big determinant is whether the US is already in a recession. The big periods when you had a real sell-off was in 2001, after the terrorist attacks in New York, and '08.
And so I don't think -- if we have a poor market from here, it's not going to be driven from what's happening in Israel, I don't think. It'll be more a function of kind of domestic economies and where we go from here, as we're in the midst of this tightening cycle.
Kim Parlee: And again, how do you -- I mean, and you can't. Obviously, in the world, what's going to happen is going to happen, in terms of -- but when you think about, like, contagion in the markets, or geopolitical contagion, and things worsening, it just sounds, as you're saying, that this is, like, an overlay onto what already is happening in the market. You're not going to -- it's not going to turn the general trajectory of what the market was already going to do.
Michael Craig: Yeah. But you do have to say there is a probability that more actors get pulled in, particularly with Iran. So, if Iran gets pulled into this, which I don't think will happen, then all bets are off, right? Then you've got a real -- you're in a real jackpot because you will see the American response. And now you've got a full-on war in the Middle East, not just within Israel and Gaza, and the Palestinians, Hamas.
So this is kind of where, again, if it's localized, you know, this probably is over in a few months. But if it spills over, then you've got real problems. In that scenario, I think, oil goes north well over $100, probably $120, $130, maybe $150 a barrel, which would be tremendously -- you'd think about a massive tax hike to a typical consumer, because --
Kim Parlee: Which already with an inflationary environment -- yeah.
Michael Craig: Yeah, it would just take another real hit to your personal income.
Kim Parlee: Yeah. When you talk about oil, I mean, I was reading, I think, earlier, where you see 50 years ago when there was conflict -- they were using an example of conflict in Israel and the Middle East. Oil had a disproportionate effect, perhaps, in the economy, because inflation was happening, recession. But, also, the world was much more dependent on OPEC oil, where it's not today. And so that really changes the dynamic, I assume, at the same time as well.
Michael Craig: Yeah, but I also think the lesson -- I talked to our Head of Commodities about this. There is a lesson that was learned by oil-producing states in the '70s. And that is, if you push that price too high, the long-term implications are countries are going to figure out ways to reduce their dependency on oil. And so, yes, you might create pain in the near term, but long term, you lose.
Ideally, what petroleum-exporting states want is a reasonably high price that's not too volatile, where they're making a reasonable profit off the spread between cost of production and cost of sale, but it's not so much that it's creating demand destruction. The last thing they want is everyone driving an EV and not using oil as much.
And so that is in the back of their mind that, OK, if they are going to use oil as a weapon, you're really cutting off your nose to save your face, if you will. So I don't think there's the incentive structure like there once was because of the lessons learned. And oil was kind of nowhere -- in the 1980s, 1990s, oil traded very, very cheap in the 20-year bear market that ensued after the '70s. And I think this is certainly on the back of their minds.
Kim Parlee: What about just if we pivot to the Fed, and the Fed has had various speakers coming out talking about how maybe the bond market has done their work for them, and then maybe they could be on pause? What are you seeing now? Like, how are you interpreting that? Or how am I misinterpreting it? You tell me.
Michael Craig: No, no, that's spot on. We have to step back and have a tremendous degree of humility right now, and I think Fed officials or Bank of Canada officials are all in the same boat. It's like, what's going to happen, right? They've just had this historic tightening campaign. In many ways, that's what is driving decision-making right now, is this whole concept of variable unknown lags from tightening of policy.
And they're looking to see, OK, what's going to happen from here? And I think what they're trying to tell you is, we think we've hiked enough, but we're just going to wait and see how this plays out. And so then I think the debate's going to go not so much more whether they're going to hike again, but how long they're going to stay there at restrictive levels.
Kim Parlee: Yeah, and what do you think?
Michael Craig: Oh, I think they're going to stay restrictive until they see a material sell-off in inflation. The lesson of the '70s was that every time central banks hiked, inflation moderated, but then unemployment started to roll over. And at the time, the mantra was, we want full employment. So they would ease right away, and sure enough, nine months, 10 months later, inflation's back to uncomfortable levels.
Nobody wants to make that mistake again. They might make new mistakes, but they are not going to take the foot off and say, OK, we're all clear, just because inflation goes back to two. They're going to want to see it there and be confident it's going to stay there for some time. So I think we're into a higher rate period for some time.
Kim Parlee: Yeah, and I guess layer into that fact, too, what we talked about earlier. It's just, if you do see oil prices go higher, that complicates things, right?
Michael Craig: It does and it doesn't. I mean, it's certainly in your CPI calculations. It's a spike. But I always think about that as it's more of a tax. If we have to pay an extra $15 at the pump, that means $15 less to go out for dinner. And, so, really, it's a hit to our standard of living. It's a hit to our consumption.
And, ultimately, where you give on higher oil prices, you kind of take back in terms of other places you'd spend money, unlike where you've got tight labor markets, or you've got wage-price spirals, or have you, which is inflation that kind of feeds on itself. This is very much more like a tax. And so, in many ways, it's almost like a hike. It's almost like an interest rate hike because it is reducing households' ability to consume.
Kim Parlee: You mentioned about wage spirals and things moving. So, I mean, we did get a fairly decent jobs report coming out. I mean, what are you expecting? Are we starting to see that market soften?
Michael Craig: You know, it's a bit of a random number generator right now. Not to get into it, but there are all kinds of statistical calculations used to formulate these. I don't think they've even really recalibrated them after the noise of COVID. And so I think that I'm kind of taking that with a bit of a grain of salt. The last jobs report was way outside of anyone's expectations.
I mean, if we see a negative on that next month, maybe we shouldn't be too surprised. I just think, right now, the data is so volatile, so choppy. ADP number was quite soft. Like, you really don't have a good feel for what's happening in the job market, and the data we're getting just isn't really giving us a clear picture.
Kim Parlee: We're going to turn our attention from talking about just what's been driving the markets recently to more what do you do about it. And so how should investors be approaching this market right now?
Michael Craig: Yeah, so, first off, whenever I get asked that question, it's always what you're trying to accomplish, what's your time horizon. If you need your wealth or your capital next year, that's one thing. If you need it in 30 years, that's a whole other. But from a more kind of here-and-now, tactical basis, I would say the following.
First, on the fixed-income side, it has been a challenging year. It's been a challenging two years. And much of this has been a repricing after COVID. It's been moving to quantitative tightening from quantitative easing. It's been this blast of inflation we had post-COVID.
But if we sit right now and look at the bond market, it is showing valuations that are as cheap as they've been since the early 2000s. So you're kind of going back 20 years, where it was this attractive. And when you're earning yields north of expected inflation by 2%, 2.5%, that's a pretty good value.
So it's a little bit like catching a knife. It has been selling off precipitously. But I think, for people who have a bit of a longer-term horizon than a week or two, it offers tremendous value.
In terms of the equity space, here, I'd be a little bit -- the world's getting a bit messier. And in many ways, if you think about where the most attractive market is right now, in terms of productivity and in terms of capital return on investment capital, you are looking at the US market.
So there are some arguments it's a little bit pricey, but it's nowhere near kind of bubble formations, and that's where you're going to get the best growth. So we still kind of like the US market. And I think, if you're a global investor, thinking about places where you're going to send money, that still is probably the market you want to go.
In Canada, it's been a bit of a soft year. I do think that this rate hike cycle is going to have a materially more significant effect on the Canadian economy than the US economy. So I'd be a little bit lukewarm on the Canadian economy. You do get the energy complex, which is interesting. But banks have not traded tremendously well, both US and Canadian banks.
And so that's an area where, you know, I think, again, valuations are pretty attractive, but you do want to see this hiking cycle pass and make sure you don't have any type of credit events. And then I think the Canadian bank side looks quite interesting in terms of that. But you do got to get through this period where you're probably going to have some charge-offs from bad loans.
Kim Parlee: Yeah, and the alts in the private space, is that...
Michael Craig: Yeah, in the private space, we love infrastructure. This is where you're seeing, in terms of the green transition, or whether it's new types of infrastructure to deal with hotter climates, or renewables, et cetera, a tremendously interesting area to invest in.
On the real estate side, not all real estate is the same. On the office space, it's a bit tough right now. But on the industrial, distribution center, multi-residential apartment, very strong demand, strong pricing. So in terms of a portfolio diversified - phenomenal.
And I would be remiss not to mention commodities, an area that we've now entered into that market. We think that, when you think about what's needed, in terms of infrastructure and basically rewiring our economy to get away from carbon, and the commodities required, and the lack of investment in commodities, the only way to resolve all this is to see higher prices.
And so we really like commodities as a diversifier and also a place to make a return within an overall portfolio. So that's kind of a thematic five-, 10-year view. But I think that's going to be not only the first decade of this century. I think we're going to see another type of supercycle in the commodity markets in years to come.
Kim Parlee: Yeah, and, as you say about the building for decarbonization, the reshoring, even the geopolitical stuff, it seems like it's kind of moving in the right direction -- or I should say the same direction.
Michael Craig: Absolutely. I mean, the tragedy that's happening in the Middle East, the tragedy that's happening in Ukraine, unfortunately, these are typically things that are going to put a bid in for commodities, just because it's making the ability to trade globally that much more challenging.
Kim Parlee: Yeah. Lots of attention being paid to GICs. They're simple to understand. You get them. You get the return. You see it there. But there are some risks investors need to think about with those, too.
Michael Craig: Yeah, I mean, the GIC rates really will mirror what fixed income rates look like. So GIC, you're playing for a couple of years. You're getting a similar kind of yield in the bond market.
I would say, for near-term investments, they're absolutely perfect. Like, if your child's going to university next year, which I'm thinking about myself, GICs make a ton of sense. You need that money in 12 months' time. You know you're going to get -- there's no risk, if you will, to what you're going to get back, so perfect.
But in terms of building wealth, I would say that, over time, they've shown to not really be helpful there. They tend to earn less than inflation, although right now is a bit of an anomaly.
And I would think, if you're an income type of investor, in the fixed income space, you're getting a similar yield. So the yield stream is not too dissimilar, and you do have the opportunity for that capital gain if rates start to normalize. So there is this lift from not only just the income but also the capital, and it's more tax efficient. So those are some things to think about if you're looking at income solutions.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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Measuring The Market Impact Of Rising Global Risks