Federated Hermes: Weekly Markets Wrap Up
In this week’s markets wrap, two experts from Federated Hermes discuss how geopolitical tensions in the Middle East, shifting inflation expectations and volatile energy prices are shaping both equity and fixed‑income markets.
Lewis Grant, Senior Portfolio Manager for Global Equities at Federated Hermes
Markets look beyond
In all our discussions regarding the war in Iran, the word that we keep returning to is 'duration'. Will this conflict last long enough to meaningfully increase inflation and prompt a global recession? The reaction of spot prices of oil and natural gas has been headline grabbing, but forward rates have proven less volatile as investors appear to be pricing in a return to a more normal environment sooner rather than later.
This explains - at least partially - why the share prices of many energy companies have not mirrored the moves in the oil price. Investors price these assets on longer term expectations and consensus suggests President Trump has little to gain from prolonged conflict and has numerous off-ramps. Indeed, he has already signalled that the end of the conflict may be in sight, and markets have responded accordingly.
We remain cognizant that while supplies of high-tech weaponry are limited, Iran could prolong disruption through targeted and persistent low-tech drone attacks. As previous Middle Eastern conflicts have shown, it is easy to declare victory and move on, but these incursions leave long lasting wounds which do not heal simply because attention moves elsewhere.
We anticipate that as the conflict fades, we will return to an environment more like January and February - a cyclical recovery aided by the AI trade, but with more broad participation than the narrow mega-cap driven markets of recent years. In this market we favour traditional value sectors. This leads us to an unusual conclusion: regardless of whether the war is prolonged (leading to higher oil prices for longer), or whether it ends (enabling the cyclical recovery to continue), we see energy names amongst those most likely to benefit this year.
Mitch Reznick, Group Head of Fixed Income – London at Federated Hermes
Inflation fears replace dovish expectations
The effects of war in Iran and the Middle East have caused a significant surge in the price of fossil fuels, elevating inflation expectations globally, leading to a pivot from disinflation to reflation. Because markets are inexorably linked, this triggered a sharp selloff in global rates as dovish expectations for rate cuts evaporated and even reversed in some markets, like the EU.
Rates markets sold off in the high single digit percents, with the gilt being the most profound at 9% in a few days’ time. The market was pricing a March rate cut at 90% at the end of February before the attacks on Iran. The rate rises lift discount rates and send risk premia higher. This, combined with genuine concerns and uncertainty about the effects of the war are putting pressure on credit spreads. Let’s put this into context.
Prior to the conflict, spreads were very tight and close to historic tights, even after the recent wobble in February. Nothing of this scale was priced in. The move in spreads is material in the context of months if not years of low spread volatility, but it does seem sensible, contained and orderly.
What is more challenging now is the rate environment and sentiment – the most important driver of spreads right now.
Headlines are coming at the market like water from a fire hose, which is impacting the price of oil, and consequently, financial markets. The question remains to what extent we are caught in the $80-plus range even as the headlines become banal with their frequency and contradictions.
When the fog clears between negative headlines, the primary market springs to life. And, while new issue premia are gapping some cases, new issues are being absorbed pretty well. The cost to trade is inching higher for lower quality credit, because the street doesn’t want to be too long on these names if we enter a more challenging market. On that note, we think those credits that are over-levered and therefore more vulnerable to the rising cost of capital or need the market to refinance, are the ones to avoid for now.