Markets look past Iran war as energy, inflation risks linger

KARI: Over the last six weeks, the United States and Israel's war in Iran has dominated market conversations. There have been a lot of changes. We've seen an escalation, we've seen a ceasefire, and now the U.S. is blockading the Strait of Hormuz. This is an issue that has been dominating market conversations and has been an investment theme that we'll discuss today.

So I'm interested, Jack, in your view, on where we've been over the last six weeks and where we could be going, depending on how this conflict unfolds.

JACK: I think if we look at what the market's telling us, the market is looking right past this because it's basically ignoring everything. If we look at things like volatility, we had a spike in the short term. But if I look at volatility going out over the next, call it, six months, it's basically back to where it had been pre-start of the war.

Look at the oil market and the oil futures curve, go out to the end of the year and oil prices are up maybe $10 to $12 from where we were pre-Iran war, if you will. Earnings haven't even budged. So we haven't seen any sort of downtick in earnings expectations. And here we are, again, market's pushing all-time highs.

So the market seems to be really looking past all of this and simply saying it's a short-term thing. We're going to get through this. It's going to be done in another month or so and then it's back to normal.

And so what's your take, though, on the political front with regard to all this?

KARI: So I think it depends. If this conflict is lingering and if it goes on longer, then the politics of the issue becomes a lot more difficult. If markets are right, then Republicans are in a pretty good position and consumers aren't going to feel that pain at the pump in November, and so they're not really going to be punished for this sort of foreign policy that happened this spring.

Now, that said, if it goes on a little longer, maybe even into the summer, Republicans are going to have to make some tough political choices on how long they support the president. And you're going to see Democrats exploit this as a political issue, given we're in an election year. So the politics really depends on the duration.

Foreign policy doesn't tend to win you elections, but it can be challenging in a year that's already really challenging, when we've seen prices at an elevated level after that inflation that we saw in COVID. So it really depends on the length, the duration, for how we see the politics of this play out.

So Jack, I'm interested in your views on which regions of the world are most impacted. You said markets are kind of looking past this, but obviously there are areas that are more dependent on the area for their energy. So where are we seeing this have the greatest impact geopolitically and globally?

JACK: I think it matters in terms of how we split this up. Because there's one thing to have access to oil but pay a higher price for it versus simply not having it. And when I start to describe that backdrop, I'm thinking of Asia, really, because the bulk of a lot of the Asia imports for energy come through the Straits of Hormuz. And so they're the ones who are going to be adversely impacted the greatest.

And, again, there's a big difference between having access to oil and simply not having it. And I think one of the areas that we're really seeing amplify this backdrop of not having it comes from the distillates market. When you get oil, you crack it, so to speak, and then you make all these byproducts. So think of things like jet fuel, heating oil, diesel fuel, that sort of thing. And it takes some time for the refineries to refine the oil to get that. It's a process that has to stay in motion.

And when you start to actually run short of oil, the problem then becomes, can you keep these refineries going? In most cases, if you don't have enough oil, you have to shut the refineries down. And these things are these massive chemical projects, so to speak. And so when you shut down a refinery, it takes quite a bit of time to get that back up. And so if we pay attention to what the distillates markets are telling us, we're seeing some still pretty elevated prices for jet fuel and kerosene and diesel and that sort of thing. And so, as a result, we're feeling the impulses and the impacts from the shortage of oil very differently depending on where you are. And Asia is really the one, I think, who's most at risk in here.

But the bigger backdrop comes back to the inflation side. And when you start to think about where we are with regard to the energy prices and then lump on the concerns that we've had with tariffs, which have been ongoing for quite some time, we certainly can see how this can become an issue. And right now, it's an affordability issue. We've certainly heard plenty about that. Your thoughts on how this all filters together?

KARI: Yeah, it's interesting when you talk about Asia, because the really big geopolitical issue that has always been the conversation in Washington over the last five years, I'd say, is vis-a-vis China and China's role in geopolitics generally. So this goes back to the Iran situation. Obviously, one of the things that we've heard about is that China was incentivizing Iran to come to the negotiation table because they are dependent on the region. We also have had this escalation in tariff tensions last year between the U.S. and China. We're currently sort of in a détente there between the U.S. and China.

And then Trump is supposed to be traveling to China in the next few weeks. We don't actually have a date for that, but that's already been pushed back. So I think it's really in the U.S. and China's interest to see this status quo hold, to see that event go ahead, that meeting go ahead. And so I think as soon as this wraps up, you see that event go ahead, that relationship continue to build, and I think that relationship between U.S. and China holds pretty steady.

JACK: When you step back and think about where the China-U.S. relationship is, it's a very tight relationship. And I think it's very hard for them to not coexist together. So if you think about it from a broader perspective, China needs us in terms of our chips, for example, and we need them for basically rare materials, raw materials, rare earths. So that relationship, I think, is very unique. And to see the tensions ratcheted up does both sides damage and really doesn't help the bigger picture backdrop.

So I think the idea that China-U.S. relationship's have taken a back seat because of what we're seeing in the Middle East, maybe that's helped cooler heads prevail and maybe we get a little bit more progress going forward on that front. But we do need to coexist. That's the bottom line here.

KARI: I think with the tariff question, we saw the Supreme Court overrule the IEEPA tariffs, some of which were on China. I think people are still asking questions to us about tariffs. And we're probably in this status quo situation just generally across the board on tariffs. The administration is going to put some tariffs back in place. Markets have kind of absorbed that. Is that your take on it too, we're at a place where markets understand where we're at on tariffs vis-a-vis China, vis-a-vis the rest of the world, and that's not as much of a story anymore geopolitically?

JACK: Yeah. There's a paper that came out from the Fed which I think is very interesting. And it talks about the impact from tariffs and its pull-through to inflation. And so obviously the Fed targets core PCE with a 2% target. And core meaning we just don't include food and energy prices into that calculation.

But they went back and looked at each tariff announcement and sequentially figured out, or at least tried to discern, what the impact was to that core PCE number. And they basically said that roughly 80 basis points worth of core PCE, let's call it 3% number, comes from tariffs. And so if we do the math on that, 3% core PCE, 80 basis points coming from tariffs, that gets us back to 2.2% for core PCE. The Fed's target's at 2%, so we're not all that far away from what they would consider to be that comfortable neutral rate, so to speak.

A couple of other things that are worth pointing out there, but the paper actually goes on to say that we've probably seen the peak impact from tariffs on inflation. And that probably came through in January. And so if you think about inflation being a year-on-year rate of change, it's going to be that 12-month moving window. Well, when was 12 months prior? It was right after Liberation Day. We're basically in that window now.

So as we start to move forward, that base effect, so to speak, that 12-month calculation that we're looking at, that starts to go up because now you're starting to take into consideration the tariffs and their impact. So that actually brings the year-on-year number lower. And so that continues to put downward pressure, in terms of core PCE with regard to tariffs. So maybe we have seen the worst of tariffs. And guess what, corporate margins are holding up and corporate earnings are continuing to still grind higher. So if the worst is behind us, that's probably a good thing.

KARI: So one of the other things that people talk a lot about is the U.S. foreign policy in the Western hemisphere. This is a big part of the Trump administration's agenda, to focus on this sphere of influence. So we saw that vis-a-vis Venezuela. And obviously that went pretty well for the U.S., the military operation earlier this year.

But there is also talk about the U.S. intervening in Cuba and in Greenland. And my expectations really are that these are not market-moving events. And also, especially re:Greenland, that the U.S. is going to work with allies, that we're not going to see a US invasion of Greenland or anything like what we saw in Venezuela. So these are not market-moving events. Is that your take on this too?

JACK: Yeah. And I think what matters most is, are these countries that we were just discussing here focal points for the global economy? Well, Iran, yes, because of all the energy that flows through the Straits of Hormuz. On a national stage, that's going to have major impacts. When you start talking about Venezuela, Cuba, Greenland, they're not really focal points in the global economy. So I think this is going to be just background noise with regard to the impacts there.

KARI: And what do you think about the sphere of influence conversation as it relates to investing? Is there anything we can take away from that?

JACK: Yeah. And this is a major theme that we've been talking about and putting into the portfolios that we manage here. Because I think that's going to be the new paradigm going forward. This is going to be more along the lines of more isolationist, less globalism, this multi-polar world as opposed to a bipolar world.

And you can probably draw those lines, as you just mentioned, through the hemispheres, if you will, going North to the South. And for us, it's considering our Latin friends. And I think that was partly what we saw with Venezuela.

But I think the bigger takeaways from us, with regard to portfolio investing, is things like national security. Those are going to be back to the forefront again, which means you need to secure your minerals. You need to secure those raw materials, those critical minerals, that you're going to need for defense building, that sort of thing.

You're probably going to see a little bit more ideas to get reshoring, onshoring so you can shore up those supply chains. Those sort of things, I think, are going to be part of the themes going forward. And that just comes back to the idea of national security. And maybe you rely a little bit more on your neighbors in your backyard rather than internationally. And I think that's one of the themes that we're really looking for.

And the bigger takeaway there also is it's probably not just going to be shared by the U.S., but it's going to be shared by Europe, by Asia, more turning inward and focusing more on themselves as opposed to maybe some of these global issues that are going to be symbiotic, so to speak.

KARI: I would just agree politically that that's a movement that we see across Europe, that we see across the US, and that we're going to continue to be having these conversations about geopolitics being a pretty big market theme for the coming years.