Living in a Kinetic World

We are living in a kinetic world. While our eyes are on the human tragedy of war with Iran, our investment committee is paying attention to the second-order effects of physical conflict and financial market volatility.

Markets fear restriction of vital trade. Energy infrastructure and shipping corridors (primarily the Strait of Hormuz) are effectively frozen by the war. When an important artery for the flow of energy constricts, it creates a ripple effect across every asset class around the globe.

Over the last week, market participants have been trying to discount the duration and severity of this conflict.

The chart below shows how various asset classes have shifted over the last 21 trading days:

• The price of oil has risen by almost 40%, from about $65/barrel to over $90/barrel for WTI Crude as of March 6th.
• The U.S. dollar has been rising as a “safe haven” asset.
• 10-year treasury yields have crept higher as market participants try to digest the tension between inflationary pressures versus the destruction of aggregate demand.
• Global equities have sold off. So far, international equities have been harder hit than U.S. stocks, as their economies may be more exposed to the shipment of oil and its derivatives through the Strait of Hormuz.

For now, the market is looking through the inflationary impacts of this conflict. In the chart below, 1-year “breakeven inflation rates” have ticked up significantly because of the war, but medium-term 2-year and longer-term 5-year breakeven rates have remained subdued.

So far the market has priced in a temporary, rather than structural, inflationary impulse.

The breakeven rate is the difference between the yield on a nominal Treasury bond and a Treasury Inflation-Protected Security (TIPS) of the same maturity. It reflects the market’s expectation for average annual inflation over that period. When breakeven rates rise, markets are pricing in higher future inflation.

Strategic Energy Buffer

About twenty years ago, the combination of hydraulic fracturing and horizontal drilling techniques transformed the energy base of the U.S. economy. Formations of shale oil and gas that had been previously uneconomic to develop were unlocked by these new technologies.

As a result, the number of barrels of oil per day that the U.S. produces domestically has doubled since 2010. The net export position for petroleum products and liquefied natural gas (LNG) has gone from a deficit to a surplus, meaning the U.S. now exports energy goods to the rest of the world.

Crude oil is a global commodity and is priced accordingly, but the U.S. does find itself with a strategic buffer against energy price volatility that didn’t exist twenty years ago. Higher oil prices act as a tax on global GDP, business investment, and consumer sentiment, but – on the margin – the surplus of energy in U.S. acts as an economic and geopolitical shock absorber.

For some historical context, we are far less likely to endure the paralysis that gripped the U.S. during the 1970s energy crisis when the price of oil quadrupled from 1973-1974.

On the other hand, countries like China, India, and Japan are more dependent on imported energy. Large percentages of their imports must travel through the Strait of Hormuz. There are tremendous global interests to ease tensions and build offramps from the conflict. Pressure is mounting.

The Long-Term View

No one can precisely forecast the impact that this conflict will have on the earnings power of S&P 500 companies in the coming weeks and months. Financial markets will remain volatile in the near term, but the stock market has been through plenty of wars.

Markets, like the people who move them, are incredibly adaptable. While we cannot predict the duration of this war, we remain focused on the long-term earnings power of the companies we own and the fact that American businesses have historically demonstrated the capacity to navigate through the most volatile periods of global conflict.  

It goes without saying that any turmoil in the financial markets is a minor concern compared to the tragedy of war and the destruction of real human lives.

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