Markets Calm but Watchful

The conflict between Israel and Hamas dominated the news last week and was also the major focus for financial markets. The situation is, first and foremost, a human tragedy; however, the market reaction was fairly limited.

Investors took comfort from the fact that the conflict should have limited global economic impact as long as Iran is not sucked in. The latter would threaten a major spike in oil prices, not least because some 20% of global oil production passes through the straits of Hormuz which are a major choke-point.

The Brent oil price rose a further $3/bbl over the week to $90 but is still below its end-September high of $97 and a long way off last year’s peak of $130.  As for European wholesale gas prices, they increased an alarming sounding 50% to €55/MWh as Israel shut down some of its production but remained way below the high of over €300 seen last summer.

Higher energy prices would boost inflation while hitting growth but the impact of the rises so far should be very limited. History certainly supports the calm reaction of markets. With the odd notable exception, geo-political crises have generally had minimal sustained impact on equities.

Global equities actually ended the week up around 1% in both local currency and sterling terms, reversing their small drop over the previous couple of weeks.  The start of the US earnings season was supportive with the results of JPMorgan, Citigroup and Wells Fargo all benefiting from the rise in interest rates and beating expectations, even while warning of tougher times ahead.

Still, the reaction of bonds made rather more sense. 10-year government bond yields declined 0.15-0.2%, unwinding their rise the previous week. With yields back to healthy levels, government bonds are once again able to provide a safe haven buffer in a risk-off environment and gilts returned 1.7% over the week. Gold too came into its own, rising 4% to $1920/oz.

The US inflation numbers for September were slightly higher than expected. Headline inflation was unchanged at 3.7% while core inflation edged down to 4.1% from 4.3%. The numbers weren’t bad, just not as good as hoped, and leave inflation, particularly in the service sector, still running at an uncomfortably high level for the Fed.

All the same, recent comments from a host of Fed officials have reinforced the market’s belief that the Fed will keep policy unchanged on 1 November and that rates have now peaked. Said officials have been emphasising that the rise in bond yields in recent weeks has tightened financial conditions and so reduced the need for a further increase in rates.

This coming week, the Middle East will clearly remain absolutely centre stage with Israel’s move into Gaza looming. That said, China will also be in focus. Third quarter growth numbers are released on Thursday which are expected to show GDP up 4.4% on a year earlier.

The September UK inflation numbers will also be watched closely, at least by UK investors, particularly following the unexpected decline seen in August. Headline and core inflation are both forecast to fall by 0.2% to 6.5% and 6.0% respectively. While the market believes that rates have now peaked in the UK, as well as the US and Eurozone, the conviction is rather less firmly held for the UK than elsewhere.

Rupert Thompson – Chief Economist