Key Takeaways
- Stock and bond markets are so far not overreacting, and behaving in line with a conflict that’s only a few weeks old.
- Even as oil prices have climbed, they remain well below historic highs.
- Major central banks look set to stay the course on interest rates, for now.
Karen Gilchrist: More than two weeks into the US-Israeli war with Iran, the conflict shows little sign of letting up. Regional fighting has wreaked havoc on crucial energy supply chains, paralyzing key Middle Eastern economies and causing oil prices to spike to multi-year highs.
Stock and bond markets are under pressure as inflation fears mount, and reverberations spill out across the global economy. To discuss all of this and more, I’m delighted to be joined by Mike Coop, Morningstar’s chief investment officer for Europe and the Middle East. Mike, thank you for joining us.
Expectations of a speedy resolution to this conflict appear to be fading. President Trump has now called on NATO allies to support the US in this conflict. What do you think is the likelihood of this becoming a protracted conflict, that kind of geopolitical shock that markets might fear?
Mike Coop Says ‘Unrealistic’ to Expect War to End Quickly
Mike Coop: That’s a great question, and one that’s really hard to answer, partly because the goals keep changing and because you have two different parties, Israel and the US, and what they’re seeking to achieve. I think one thing we can be clear about, it’s going to be really difficult to remove the current regime. It will be equivalent, dare I say it, to the de-Nazification of Germany. This is a very entrenched organization, through all tiers of society, which would require you to have land troops and for you to be there for a long period of time with many other countries.
That seems highly unlikely. So to that extent, it’s going to be a world where the regime continues to operate in some way, shape or form. It’s got its own agenda, which at the moment appears to be survival. And in a way, Trump can say that he’s achieved the original aims, which is to, if you like, defang some of the military prowess of that regime. And also to do major damage and setback on their nuclear program. So there is a world in which, actually, it could end tomorrow with him saying, look, I’ve achieved my goals. It’s unlikely that that’s really what Israel would want it to achieve, but you feel that he has the whip hand here. So that is certainly one scenario.
But if the incentives are for a more lasting peace — and the challenge is that now you’ve also got a conflict that’s spread to the whole neighborhood — that is a big change from how things operated in the last 10 to 20 years. So it does feel like it would be unrealistic to expect this to be over quickly.
Markets Are Behaving Logically at This Stage
Karen Gilchrist: Understood. Now let’s talk about the market impact. We did, of course, see the initial sharp selloff, but it has been somewhat a benign reaction overall. Do you think markets are mispricing this? Are they being too complacent?
Mike Coop: It’s one of those periods when normally markets tend to overreact. You’ve seen some of that in the initial positioning around oil price futures. But unlike the tariff Liberation Day last year, we’re not really seeing that overreaction. And, actually, as investors we typically expect that to create opportunities. So in terms of how equities and bonds are behaving, so far it’s logical when you consider that the conflict’s been running for a pretty short amount of time.
We went into this with oil prices quite low, really in the $50 range at the end of last year. So although the percentage increase has been pretty big, it’s come from a low base. And it’s been a relatively short period of time. So the big unknown there is really the length of time in which supply is severely constrained, either through the destruction of the capacity to generate oil and gas, or the ability to transport it.
The thing that seems to make that less likely is the fact that Iran supplies oil to China, and China continues to have significant influence. And in fact, there’s still oil being shipped out to China. And India’s another important customer. So to that extent, it’s logical not to suddenly price in a USD 200 oil price. But in the countries that are exposed from an inflection point of view, which is Europe, it’s the UK, you’re seeing more of a hit to the bond market, as people reprice inflation and rethink interest rates.
Oil Prices Remain Well Below Historic Highs
Karen Gilchrist: You’ve of course touched on oil prices there. We did have that emergency release from the International Energy Agency last week, but that did little to quell concerns. We’ve still got oil prices over USD 100. We’ve got LNG prices also sharply higher. Do you have a sense of where you see prices going from here? You said not USD 200, but do you have a sense of how high they could go?
Mike Coop: What’s interesting about the release is that we don’t know what the prices would have been had they not done that. And, certainly, had they not been willing to do it, it probably would have sent a signal. So, in my view, it’s probably helped contain the price increases. If you look at the forward curves, it’s suggesting that oil is expected to come back down pretty quickly. And really by the second half of the year, back to the range we’ve tended to see it in the last few years. So that suggests that there’s some measures that could be taken by countries.
We’re seeing that already in terms of trying to rein in their potential spending. We’ve also seen the interim release of embargoed Russian oil that is now being made available without the sanctions that would normally apply to it. And there’s also the existing ghost fleet out on the sea with the oil that’s there. So that’s why at this stage we haven’t really seen a dramatic price increase.
We’ve also seen a ratcheting up of Iran disrupting travel through the Strait of Hormuz, and its neighbors. So, at the moment, it’s starting to have an effect, but it would need to continue for some time. So because of that, I think the balance would be that the oil price above USD 100 would have to be expected for some period of time. Let’s not forget, in the past the oil price has been USD 150 back in 2007, for example. And in the Ukraine conflict it got up to, at one point, nearly USD 150 for a short period of time. So it’s early days, and prices are nowhere near that level at the moment.
No Drastic Shift in Central Bank Policy for Major Economies
Karen Gilchrist: Nevertheless, we have seen these rising concerns about a spike in inflation. We’ve had money markets adjusting their forecasts for central banks and their rate cutting agenda, potentially looking at hikes, maybe. Where do you see inflation going? Do you think there is a risk of this spike in inflation, potentially stagflation? Do you see a meaningful adjustment in central bank policy to?
Mike Coop: They say the best cure for a high oil price is a high oil price. And what I mean by that is that it eventually destroys demand when the price goes up. When we look at inflation, previously we thought that inflation was starting to get back down to the target level for central banks, the sort of 2%. And that was expected to continue here in the UK as well as in the US. So far, the effect of the higher oil price expectations is people appear to be adding about a half-a-percent to their oil forecasts for the UK, near-term. And a smaller amount in the US, where they are more self-sufficient in energy and the gas prices are a lot lower.
So the inflation picture isn’t drastically different. It’s in no way equivalent to what happened in the 1973-74, or ‘79-80 conflicts, really. So central banks also will consider is this a structural change that I can control and impact by raising interest rates? Therefore, there’s some likelihood that they’ll look through the initial increases before they act, particularly where economies are not in great shape, and growth is anemic. We suspect that’s likely to be the case somewhat in the UK and probably in Europe.
It’s more the countries that are more exposed are those who have a bigger pass-through of the oil price impact on their inflation, which are some of the more minor, emerging market countries. But we don’t really see it dramatically changing what’s happening in the US or the UK, partly because there will be demand destruction and partly because also you’re getting a big disinflationary impulse coming from AI, and the and the take up of AI. So when you step back and ask what are all the factors that could impact inflation? Yes, oil is one of them, but it isn’t the only one. These other things are quite major in terms of the effect they’re having.
Investor Opportunities Exist with Diversification
Karen Gilchrist: Interesting. Now, Mike, it is a very challenging environment for investors. How do you think they should be thinking about managing this risk? And is there a difference in strategy if this is a long war versus a short one?
Mike Coop: That’s the key question exactly, Karen: how long it lasts. And, frankly, how to react? Now, usually, it’s better to admit that you can’t forecast what’s going to happen and have some exposures in your portfolio that provide you with offsets in these scenarios. Things like inflation-linked bonds, perhaps. Or defensive sectors that are going to help you if things really end up causing a recession, for example. So those are things that we tend to hold in our portfolios as well, because we just don’t know what’s going to happen. And if the price is decent when we buy them, then that will help our overall returns whilst covering that scenario.
It’s a bit late to be rushing out and buying those things right now, in terms of things like energy, the shares in energy companies, which are obviously doing much better as a result. There has been some degree of currency moves, and having that currency diversification has been important to have in portfolios. So I think it’s really a case of, for those who have very low risk tolerance, making sure they’ve got appropriate diversification, and that the risk they’re going to get is comparable to what their tolerance can handle.
But for other investors, in our experience, it’s often creating opportunities. So if it turns out that things do appear to get worse in the short-term, if there’s a strong market reaction, I think we would see that as an opportunity. And in previous crises, that’s what we’ve found has been pretty effective. We picked up some pretty cheap assets in the selloff around the Liberation Day, and then the Covid shock prior to that. So we feel that that could be something to look out for. But at the moment, it’s really a case of having the appropriate diversification.
Energy Stocks, Defensive Assets Look Set to Outperform
Karen Gilchrist: You’ve said, of course, you don’t know what will happen. But do you have a sense of what could be some potential outperformers in this market?
Mike Coop: So the current trends give you a pretty good indication. If it were to continue, it’s likely that the energy futures would go up. It’s likely that the share prices of energy companies could also go up.
There is this weird tipping point though, where, as I say, it switches from being an inflationary shock to one that starts to hurt growth. And so, in that environment, it’s the defensive assets that can be durable. So bonds are an interesting case in point. They’ve sold off as investors have rethought their interest rate expectations. But there’s a point at which if a demand destruction comes through, actually bonds could rally quite strongly.
So I think there’s the immediate impact. But the further out you go, if you really thought this is going to be a severe shock, then you would be looking at some of those more defensive assets as being beneficiaries, some of the safe-havens.
Investing Fundamentals and Wider Trends Remain Key
Karen Gilchrist: By the same token, any assets that investors might look to avoid while we’re in this period of great uncertainty?
Mike Coop: The other thing I should mention is inflation-linked bonds is something that we’ve also held because we think it’s a great insurance policy. And sure enough, it’s playing out as well. Yeah, I think [in terms of] avoiding things, markets are pretty efficient at sniffing weaknesses and pricing assets. And when you get the reporting season, you see that and the responses.
I would say people shouldn’t take their eye off the ball when it comes to the effect of AI. So that’s something that we’ve closely looked at, and Morningstar research has demoted several companies who they believe their competitive advantage is being eroded. So that’s also really important, and the funding model.
I think there’s nothing specifically around oil itself that would cause people not to hold. But it’s more vulnerable companies, with weak balance sheets, where they’re particularly exposed, you want to have comfort that the price of the asset already reflects the bad news, and that they’ve got the staying power.
