An inconvenient truth
Investors concerned about market volatility stemming from escalating tensions should consider a balanced approach in allocating exposure to energy stocks.
Sports can never be completely separated from politics. During the recent Chess Olympiad in Budapest, which I had the privilege to compete in, the impact of the ongoing tensions in the Middle East was apparent as a few matches were cancelled. Away from the chess board, the ongoing conflicts are also starting to leave its mark in financial markets.
In recent weeks, the Middle East tensions have escalated to its most dangerous level. Brent oil is up nearly 15% from the September low. Historically, central banks have not usually responded to these temporary supply shocks, especially since oil prices are still near the bottom of this year’s range.
However, the latest rise in oil prices comes against the backdrop of some central banks seemingly declaring victory against inflation, and the aggressive monetary policy easing priced into bond markets. In this environment, a sharp rise in oil prices can quickly become an “inconvenient truth” for global asset markets. In turn, higher oil prices, combined with the reduction of China-related downside risk and stronger-than-expected US economic growth data (such as the September job market report), can derail the Fed rate-cut path that markets have been projecting in recent months. The archenemy of investors, i.e., inflation, may creep back into the picture.
With nearly 150bps of additional Fed rate cuts priced into markets by end-2025, investors may find themselves running too far ahead of the Fed. As such, there is a risk of US rates squeezing higher if a US economic soft landing remains the base-case scenario.
Thus, the picture is getting quickly more complicated, and the markets are not necessarily discounting that yet, in our view. US equities, especially the technology-focused Nasdaq 100 index, are facing technical resistance. Hong Kong and China equities have risen sharply in recent weeks, but valuation is still not demanding. Against this backdrop, we believe investors should seek out laggards, for example, in the Chinese consumer discretionary and communication services sectors – two areas where we are overweight in China. For US equities, we have a ‘barbell approach’, wherein we rotate into the more defensive healthcare sector, especially as volatility rises in the run-up to the US elections in November.
What do we expect from oil and energy stocks? Back in April, Iran’s missile attack on Israel essentially marked the top for oil prices this year. However, the current investor positioning is very different. Brent and WTI crude oil contracts are still very much under-owned, compared to the middle of April. Oil prices have historically delivered strong returns when the market is so under-owned by investors.
Another positive driver for energy assets comes from the trend-following strategies, such as CTAs. November and December have historically been strong months for commodity trend-following strategies. Strong upward momentum is likely to beget more CTA buying. Technically, trigger levels for further buying in brent are now at roughly USD 84 per barrel, which is about 8% above the current level.
Investors who are concerned about a likely surge in market volatility stemming from any sharp rise in oil prices due to escalating Middle East tensions should consider a balanced approach in allocating exposure to energy stocks, which are under-owned by market participants.
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