In Times Of War
I’m going to go out on a limb here and say that it’s a good thing for risk assets that the official word on the strikes in Syria came late Friday evening (in the U.S. anyway) after markets were closed for the week.
I don’t want to suggest that the market reaction was high on anyone’s list at the White House in terms of what to consider when pondering the strikes on the Assad regime, but you’d be remiss to think it wasn’t at least on the list of concerns.
The geopolitical headlines market participants were force-fed this week were at times so momentous and at other times so surreal that analysts and financial journalists alike struggled to find the right words to express their incredulity. Everyone I talked to this week said the same thing which, in a nutshell, is that irrespective of your political leanings, the nature and frequency of the headlines during the trading week is unprecedented. Here’s an example of a random CNBC screengrab I tweeted out mid-week:
That headline of course references President Trump’s Wednesday morning tweet regarding Russia’s stated intent to shoot down U.S. missiles fired at targets inside Syria. That tweet was bombastic to the point of being cartoonish and it left markets to ponder the unthinkable – a direct military confrontation between the U.S. and Russia. The moment it hit is clearly visible on all manner of charts, but the one I want to show you is this one:
What you should note there is that the missiles tweet came at a time when the ruble was already extremely vulnerable. I spent all week over on my site documenting the trials and tribulations of Russian assets in the wake of the latest U.S. sanctions which roiled the ruble, Russian bonds, Russian equities and the aluminum market. On Monday, in my last post for this platform before the headlines started to come in so fast that documenting them on Heisenberg Report became the only feasible option in terms of timeliness, I talked a bit about the impact the sanctions were likely to have and I highlighted some color from several of the big banks, so if you need a review, that’s a decent place to start.
Note in the chart above that the ruble was essentially bailed out by Steve Mnuchin on Wednesday afternoon following the Trump tweet. The Treasury Secretary seemed to rule out sanctions on Russian government debt (the so-called “nuclear option“) relieving some of the pressure on Russian assets in the process. Here’s what Deutsche Bank wrote early in the week about market psychology following the latest sanctions:
Markets quickly switched to thinking the unthinkable, whether sanctions could be extended to the OFZ market. We believe at this stage it is unlikely. Targeting OFZ is the final lever that the US administration has and it may keep it in reserve.
Right. And make no mistake, if the U.S. were to pull that lever in response to further geopolitical tensions with Moscow, it would be bad news. Here’s a look at the ruble plotted with Russia CDS (you can see the selloff in the currency and the abrupt widening in credit risk):
Global markets aren’t going to be particularly inclined to catch cold immediately if Russian assets sneeze, but if you’re long risk, you don’t want to see a scenario where this spirals too far out of control, because eventually, it will spill over into emerging markets more broadly.
So you need to think about Friday’s airstrikes on Assad regime targets in that context if you’re an investor. Also, note that in the event Russian assets are hit by these type of political concerns, rising crude prices won’t necessarily offset the pain. Indeed, if you looked at the ruble on Wednesday morning (so, in the heat of the moment, as it were), it was on track for its biggest one-week underperformance of Brent since 2009:
(Bloomberg; through Wednesday morning)
Speaking of crude, this was a blockbuster week. WTI posted its biggest weekly gain since July, rising nearly 9%:
There’s nothing quite like an acute escalation in the Mideast to prompt investors to price in a geopolitical premium in crude and you’re reminded that at the end of the day, this always comes back to the same question: what’s the read-through for the odds of an outright confrontation between Tehran and Riyadh?
I’ve written a ton this week about Douma (where the chemical attack occurred) in an effort to give readers a bit of background on the fight for Eastern Ghouta. I’m not going to get too far down that rabbit hole here, but suffice to say there’s a Saudi connection to the rebels there, and as you’re hopefully aware, Iran is the Assad government’s staunchest ally. This all comes at a critical time for relations between Washington and Tehran and that has implications for crude. Here’s a bit of color from a new Goldman note discussing what the effect on crude might be if Trump decides not to extend waivers on Iran sanctions next month:
If the US reintroduces the secondary sanctions, we would expect European refiners to reduce imports from Iran, even without participation from the EU, given their exposure to the US, either through assets or product trade flows. The EU accounts for 25% of Iran’s 2.6 mb/d crude exports but we believe the key for the global oil market is whether these flows will be curtailed rather than simply redirected to Asia.
Key to the impact on the oil market would be how Saudi Arabia decides to respond. Potential losses from Iranian production would support oil prices by $ 7/bbl (assuming 500 kb/d outages for 6-mo, and modeling the impact of such an inventory shock on timespreads). This 10% increase in prices would halve the export revenue impact for Iran. So in this situation, Saudi Arabia may decide to increase production to prevent higher oil prices from softening the impact of the sanctions on Iran. Net, while the reintroduction of US secondary sanctions on Iran is increasingly likely, the lack of global coordination suggests a limited production impact initially. Of course, the odds of steeper military escalation in Iran have increased with the recent changes in the US administration. Further, a direct conflict between Saudi Arabia and Iran could create a dramatic impact on the oil market if local producing or refining assets were impacted.
This is all particularly interesting in the context of the Saudis’ purported desire to see crude at $ 80 per barrel ahead of the Aramco IPO. As you can surmise from the above, this is a rather delicate balancing act and there’s a lot more at stake than just the fate of U.S. shale. Incidentally, thanks to a Bloomberg scoop out Friday, we now know that Aramco is the most profitable company in the world by a fairly large margin:
(Heisenberg, Bloomberg data)
As far as other assets, I think it’s entirely possible that all of this supports equity volatility in the U.S. next week. Multiple sellside desks have warned that the potential for a “sell the news” dynamic to unfold during earnings season is high, and if you were watching the banks on Friday, it seems like we got a preview of just that kind of mentality following results from JPMorgan and Citi.
Coming full circle, it’s of course possible that the timing of the airstrikes will give markets a couple of days to calm down and that temporal cushion could mute the reaction. On the other hand, Russia is most assuredly not pleased, and although their options for retaliating are to a certain extent limited by fears of further economic reprisals from the West, the rhetoric is likely to remain heated for quite some time.
For now, I’ll leave you with a chart from Barclays which plots a news-based measure of geopolitical risk:
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.