Hopes of a swift resolution to the conflict in the Middle East are being challenged by recent events. We have once again seen the ‘closure’ of the Strait of Hormuz by Iran and a blockade of Iranian shipping reinstated by the US.
Low-level attacks have continued by both sides, leaving the ceasefire and memorandum of understanding to deliver a framework for a longer-term peace deal at risk of collapse. US president, Donald Trump, recently declared the ceasefire to be ‘over’ and while talks continue at a technical level, the deep levels of mistrust between the US and Iran, combined with the ongoing skirmishes over the control of shipping, mean that progress appears limited.
The fact that talks have failed to go beyond the status of the Strait of Hormuz on to more complicated matters around Iran’s nuclear programme suggests this conflict may endure longer than feared. The global economy has shown significant resilience so far, helped by the fact that despite spending some time above $100 a barrel, and spiking twice around $120 a barrel, the oil price has not reached some of the doomsday levels feared at the start of the conflict. This has been helped by inventory drawdown, measures to curtail consumption, continued supplies exiting the Gulf by ‘stealth’, use of alternative routes and maximising the capacity of pipelines, and a belief the conflict would be short lived.
For the moment, equity markets appear to be taking the conflict in their stride, with strong earnings and no significant deterioration in the economic growth outlook helping to maintain sentiment. However, concerns are clearer in bond markets, which have shifted from worries around growth to focusing on the impact on inflation and the outlook for interest rates. So far, the inflationary impulse from the conflict has been visible but relatively limited, with little follow through beyond energy prices. A longer conflict resulting in elevated commodity pricing, extending into food pricing, poses risks to the benign impact we have seen to date.
Despite the elevated tensions, the prevailing view remains that while the conflict may endure at a ‘low’ level, neither side has the appetite for a return to full-blown conflicts. Given the favourable terms offered to Iran to come to a longer-term deal, with numerous concessions made by the US in return for normality around the Strait of Hormuz, there remain large incentives for both sides to return to high level talks. But that does not mean that such a move may come immediately, and the risks of supply disruption and elevated pricing stretching beyond the summer have clearly increased.
Overall, we continue to maintain our positive views: discussions have taken place in the team on increasing our overweight to equities, but we believe the best opportunity to do this will come if we see a market pullback in coming weeks. While geopolitical tensions will continue to weigh on sentiment at times, the resilience of the global economy and strength of corporate earnings suggests that market momentum can be sustained for now.
At a glance – equities and fixed income
Equities
We remain positive on equities and, despite geopolitical uncertainties, we anticipate ongoing strength in corporate earnings to drive equity returns further. Corporate fundamentals, which remain solid, are not showing a notable impact from the geopolitical uncertainty. We are comfortable to maintain our equity overweight at ‘mildly favour’ but continue to discuss the potential for an upgrade to this view – the catalyst for which may well be a pullback in markets that offers an attractive entry point provided fundamentals remain supportive.
Fixed income
We retain a neutral view on bonds. Government bonds continue to show volatility and sentiment continues to shift, but inflation concerns persist. Longer-term concerns over debt and fiscal deficits remain, and as the moves in UK gilts suggest, political stability and risks with an imminent change of leadership continue to linger. Views on the outlook for rates continue to evolve, with the positive news from the Middle East in June being erased by more recent events. This has resulted in markets once again starting to price in more than one rate hike across the US, UK and eurozone. Valuations in investment grade and high yield bonds remain relatively unattractive, and along with emerging market bonds offer historically low spreads, suggesting limited capital upside and returns limited to ‘coupon clipping’.
