Iran war, oil backwardation, and the Fed’s next move

JACK JANASIEWICZ: I'm Jack Janasiewicz.

BRIAN HESS: I'm Brian Hess.

JACK JANASIEWICZ: And this is Tactical Take. Very good.

BRIAN HESS: Jack, there's a lot going on with the U.S. attack on Iran, so I thought it would be a good time for us to sit down and catch up briefly. We're recording this on March 10, and so it's the 11th day of the war. Just yesterday, Mojtaba Khamenei was announced as the new Supreme Leader of Iran. Oil surged more than $100 a barrel before reversing sharply in the afternoon. And President Trump, presumably, in an effort to calm markets, said the war could be over very soon.

So I guess, first off, since this is a show about macro investing, we'll mostly limit the discussion to the impact this war is likely to have on markets, rather than getting into the politics of it. And with that in mind, I'm wondering how this latest incident changes your views on the major asset classes. Let's just start there at the highest level.

JACK JANASIEWICZ: Yeah. And it's still, I think, to be determined because the big inputs are, obviously, going to be how long and how high the oil spike goes. If we see a persistent spike of oil north of $120 a barrel, for example, and that lasts for months, obviously, those are going to have significant ramifications for the global economy. If we have something that just pops up for a week or two, then we move right back down to more normal levels, then, obviously, that'll be a much more short-term impact.

I think the one wildcard here that maybe we didn't appreciate going into this after we were thinking through this is the damage to the infrastructure across the rest of the Middle East. We've seen Iran, basically, launching missile and drone attacks on their neighboring countries, and that's been upsetting and destroying some of the infrastructure there, whether it be refineries or shipping lanes. And that's going to have some longer term impacts as well.

So lots of moving parts here. And obviously, the longer this takes to get to a finish, the more impact it's going to have on the global economy.

BRIAN HESS: So basically, too early to say is the bottom line. But now, you're worried about maybe some supply shortages or a mild or repeat of some of what we saw in 2022.

JACK JANASIEWICZ: Yeah, and keep in mind the issue is not really necessarily the oil price itself, it's physically lacking the ability to actually procure oil. And I think that's the bigger issue when we start talking about countries coming out of, for example, Asia or even in Europe, U.S. is still fairly independent, because we're an exporter of energy. But we'll feel the impact from higher prices, but we'll still have access to it. But some of these other countries just won't have access. That's a very different outcome here.

BRIAN HESS: Yeah, when it's not available at any price—

JACK JANASIEWICZ: Right. Exactly.

BRIAN HESS: --that's a whole different story. So other than the price of oil coming down, which is, I think, the obvious one, what else should we be looking at to suggest, maybe the worst of the volatility is behind us? Are there any checklist items that we're working off of here at Natixis as we think about foreign investing?

JACK JANASIEWICZ: Yeah, we've discussed this in our investment meetings. I think the big one is just paying attention to what that forward curve looks like for oil. And as we were joking earlier, backwardation, that's the key thing that we're seeing in the oil market.

BRIAN HESS: When the near-term contracts higher priced than the more distant ones.

JACK JANASIEWICZ: Yeah. And so just looking at those farther out contracts, are we seeing those oil prices start to move up? Because if they are moving up, then that's telling us that futures traders for the commodity markets are expecting, maybe that equilibrium price to settle at a higher range than we were previously in. So that's one of the bigger issues there, I think, that we're paying attention to.

The second one, and maybe this is more specific to the U.S. markets, it's really inflation expectations. Because if we start to see higher prices at the pump and then that's, ultimately, going to filter through into the broader goods portion of the market, even in the foods area of the consumption baskets, do we start to see investors or just normal people getting concerned about that price that they're paying? Are they going to start to adjust their inflation expectations higher, and then do we have to bring the Fed into this whole thing?

So I would say the two things there, what are the future oil prices looking like, and then what are inflation expectations looking like. And so far so good. But again, as this draws out longer, those can change.

BRIAN HESS: Yeah, if you look at something like the December 2026 oil contract, it's definitely up. It's off its lows, but nowhere near $100 a barrel. So that's saying it could be a short-term impact. And same thing on the expectations for inflation, one year, one year forward, inflation expectations are still in the range they've been in for the past couple of years.

So nothing too alarming, yet on those fronts.

JACK JANASIEWICZ: Yet.

BRIAN HESS: Now, when it comes to the Fed, which you just referenced, how do you think they're likely to treat this situation? On the one hand, there's the risk of inflation pass through from the oil prices. On the other hand, there's the negative impact to growth.

JACK JANASIEWICZ: And it's interesting too because we were looking at this the other day. If you actually decompose the nominal yield change that we've seen in more recently, you can decompose that into both inflation break evens or inflation expectations and real rates. And so we can measure real rates through the tips market. And then you can look at breakevens or inflation forwards or however you want to describe inflation expectations in there.

But as we've seen nominal rates pushing higher for tens, we've also seen those inflation break evens tipping higher. But at the same time, we've actually seen real rates coming down. And so what that's implying, at least short term here, is that the market is getting a little more worried about growth. And we're seeing a little bit of an uptick in the concerns about inflation. Now, nothing to run away from here, but something to, basically, keep in mind as we push forward, the market is starting to think about that.

And so take that all the way to what the Fed potentially could be doing, and there's a risk here of a policy mistake. I think that's where you start to see the bigger concerns kick in. Because if the Fed's reaction function is going to be looking at that potential increase in inflation expectations, then you probably start to see the Fed potentially having to hike rates in here.

And if you look at what the futures market is telling us on interest rate hikes and their expectations between now and the end of the year, we were pricing in something close to two cuts by December. The market has taken roughly about one cut away. So we're still talking cuts, fewer of them. But the risk is that that continues to move, and the Fed actually acts on this.

And if you actually go back and look, I think Bernanke had written a paper in maybe the mid 2000s talking about this, what is the impact to inflation with regard to the Fed's, the way they look through this or should they act on it. And the idea here is that as inflation pushes higher, it acts as a consumption tax. So it slows consumption. That slows the overall economy.

And then if the Fed is going to react to inflation, they're going to hike rates, and that's just going to exacerbate that slowdown. So you're going to have demand destruction, which will probably eventually take care of inflation worries, but you're exacerbating that potential growth slowdown with Fed hikes. And as a result, maybe growth slows even faster, and that becomes an issue.

So at that point growth then trumps inflation. So the risk here is that you get, actually, a Fed tightening, and that just exacerbates the issue into a full-blown recession.

BRIAN HESS: So the Bernanke paper would suggest the Fed should look through this shock for now and avoid the risk of exacerbating the growth slowdown and actually, creating a recession out of what could have been just a minor shock.

JACK JANASIEWICZ: Yes. The risk here, though, I think, is, if you go back in history and look at what Warsh has talked about, who's going to be the new—

BRIAN HESS: Oh, and that's the wild card. We have a new-- yes.

JACK JANASIEWICZ: Warsh has actually talked about his concerns with inflation, as a result of commodity price spikes, so throws a little bit of a potential wild card into this whole thing.

BRIAN HESS: Wow. Makes it even more interesting. How about the ECB? They're well known as targeting headline for targeting headline inflation as opposed to core inflation. And that's going to be directly impacted by the oil price spike. Not to mention they are having a price surge on natural gas as well, not nearly like in 2022, but it is up.

And the market there, if I'm not mistaken, is flipped from pricing, kind of like nothing or maybe minor chance of cuts to now, pricing at least one hike by the end of the year. This is for the European Central Bank. Do you view that as a potential policy mistake as well?

JACK JANASIEWICZ: Yeah, it certainly would seem so. And I think if you think about where the European economy stands, one of the weak points that they've had, historically, is basically the higher price of energy that they're paying to, basically, run the manufacturing sector.

So they've already been getting squeezed by commodity prices in terms of the cost of manufacturing, so to speak. That's not going to help things. And then factor this in and then the potential for, you just said, the rate market is certainly pricing in at least 1 hike, if not 1 and 1/2, closer to 2. Now, you're going to have an ECB hiking into this.

So certainly, I think there's a greater risk for the potential for increased recession odds in Europe as a result of that versus maybe, say something in the United States, so to speak.

BRIAN HESS: Yeah, and we have seen that historically. I remember back in 2008, there was a rate hike from the ECB because oil prices were surging. And I want to say, even in 2011 or 2012, they had a mistimed hike at the start of that European financial crisis.

JACK JANASIEWICZ: Suspect track record.

BRIAN HESS: The track record suggests it's a risk. So Europe, I guess, is one area where they could be kind of in the crosshairs, and that's one that we might want to de-emphasize in terms of our risk taking. How about any beneficiaries that you're seeing around the world, as you look for opportunity?

JACK JANASIEWICZ: Yeah, and it'll still be the exporters, obviously. And there's certainly pockets of exports that you're going to see, net exporters of energy that you'll see coming out of emerging markets, and specifically, I think our neighbors to the South. So Brazil and Mexico were going to be net exporters will potentially benefit from a prolonged spike in oil prices or energy prices, in general.

So you're starting to see some of that play out within the terms of trade as well, within the currency markets. You can see some of the currencies are really depreciating relative to the dollar in here, and those are the ones that are going to be the high-energy importers. So you can start to see the terms of trade shock working its way through the system via the currency markets as well. So that gives you a little bit of an indication as to who's going to be net beneficiary, so to speak, going forward as well.

BRIAN HESS: He did mention Japan yesterday, as maybe a beneficiary people don't think of immediately, and that's thanks, to their linkages to the U.S. defense industry. So could Japan, ironically enough, be potentially a winner?

JACK JANASIEWICZ: Yeah, and the one thing I think that also, maybe people are underappreciating too, is Japan has their version of the Strategic Petroleum Reserve as well. And I think their total numbers are something close to 255 days worth of imports there. So Japan actually could probably maybe weather this a little bit better too, if they decide to tap into that reserve, so one of the positives from their perspective.

But to your point, when we start to expand the backdrop with regard to Japan, as we talked about, they have a finger in all of these trends, in these crosscurrents that were positive before—

BRIAN HESS: The secular trends we've been operating with, whether it's greater defense spending or regionalization, deglobalization, those types of things.

JACK JANASIEWICZ: Yep. And then on top of the shift that they've had with the prime minister, who's been much more open to fiscal stimulus. So we've certainly seen plenty of positives that have been emerging there on top of the corporate reform story, and that's been going on for a couple of years now.

But from the perspective of proxying up and helping out the U.S. with regard to the defense manufacturing portion of the industry, I think I was a little bit surprised to see how much Japan has actually had become a major player, a major supplier in terms of the defense industry for the U.S. And so we should expect that to continue to grow as well as we need to really restock and replenish the arms that we've gone through, given all the conflicts that we're talking about right now around the world.

BRIAN HESS: And Japanese stocks have been hit pretty badly, because they are known as a big energy importer, so those stocks have been hit. But if there's a large Strategic Petroleum Reserve and this defense connection, that could be an opportunity.

JACK JANASIEWICZ: Yeah, exactly. And, I think some of this is also some crowded trades, coming into this as well. And so we've had volatility spike. I mean, the VIX got over 30 at one point. VIX, again, the implied vol, 30-day implied volatility, the S&P 500. That got north of 30, which is a significant spike higher, more than one standard deviation above trend.

And when you get those kind of spikes, it forces de-leveraging from your value at-risk models there in the leverage community. So these big winning trades that we had seen prior to the Iran hostilities saw massive unwind, and Japan got caught in those crosshairs as well.

BRIAN HESS: For sure. Yeah, I think, in general, markets came into this episode with very little risk premium embedded in the prices. And so I'm surprised in some cases, there haven't been bigger corrections yet. Certainly, Korea has gotten hit hard. Japan has gotten hit hard. But other places like the S&P 500, for example, it's really not off by all that much.

Now, coming back to the U.S., last week, we had conflicting economic reports between the PMI surveys and the employment report. We talked about how the big risk to the U.S. economy is that oil prices stay high, consumer takes a hit, and we get a shock that really slows growth. So I thought we could look at those two releases, and I'd just like to get your opinion on which one you're putting more credence in at the moment.

So the PMI surveys, we had both manufacturing and services above 50. But the services PMI moved all the way up to 56, which is a strong reading. And the new orders for both series were solid, well above 55 and showing expansion. Yet at the same time, the economy lost 92,000 jobs in February. There were downward revisions to the prior two months, and based on the establishment survey, we haven't created any jobs since May of last year. So which of these two inputs do you put more faith in?

JACK JANASIEWICZ: If I'm bullish, I put them in one. If I'm not, in the other. I think at the end of the day here, when you start to think through what we're seeing, some of this really comes back to the idea of the productivity gains. And we can make some arguments here about whether we're seeing the impact of AI filter its way through. We might be a little bit early on that, and that's maybe a little bit suspect in terms of drawing that sort of conclusion.

But I think you're starting to see some of the payoffs coming from COVID, where you had pretty good job turnover. People are now settled into their jobs. So the longer you're in your job, the more productive you're going to be because you get what you're doing, and you have a better understanding of what you're doing.

And you're starting to see a little bit of the fat cut, for example, massive overhiring, for example, coming out of the tech sector. Some of that is getting trimmed off. And so the point here is we're still holding up fairly well from a GDP perspective, but we're doing it with less people. And so I think we're starting to see some of this story.

And basically, this comes back to what you're just pointing to, the PMI surveys. Still decent. Jobs are, certainly, at least slowing from the hiring perspective. We're not necessarily seeing that firings. That still remain somewhat benign. So we're basically, doing a lot more with fewer employees.

So I think we are starting to see some benefits of productivity. And then if you start to think about it in the future, if we start to see the AI impact kick in, that's probably only going to be accretive going forward here. So again, this goes back to one of our concerns going forward, how long can we continue to see this persist without seeing a marginal slowdown. Our guess is we do see a slowdown at some point here. But again, we're slowing from decent trends back to something more normal. That's not a bad environment, and it still keeps the Fed in play as well.

BRIAN HESS: So it sounds like for now, we're not too concerned about the loss of momentum in the employment. I mean, if we start losing 200,000, 300,000 jobs a month—

JACK JANASIEWICZ: That's a different story.

BRIAN HESS: --that's going to be a whole other story. But we're at a level of job loss right now where it's still manageable. And it speaks more to maybe, productivity gains, as opposed to a lot of concern within corporate sector.

JACK JANASIEWICZ: And without a doubt, the labor market continues to slow. However you want to look at it, we are seeing signs of slowing. Wage growth is coming down. And the other thing to think about too, is I think we're seeing a little bit of signs that that sort of savings rate is being depleted as well.

So that cushion continues to shrink. The question is, when do we finally get to the point where that's been exhausted. And then you finally start to see consumers pulling back, for example, and you start to see, maybe, some slowing, even more so accelerated with the job gains.

BRIAN HESS: Which is why this situation with Iran is coming at an interesting time. Imagine if the S&P tumbles 20% because of the oil price spike. There goes the wealth effect and that support to consumption,

JACK JANASIEWICZ: Yeah. And we've talked about on previous podcasts here, the K-shaped economy and who's been driving that K shape. Well, it's been the upper echelon income earners, and those are the ones who are really benefiting from the stock market. And so if we do get that correction that you're alluding to, does that do some serious damage to consumer confidence going forward? And if it does, the one bastion that's been holding up consumption here starts to crack, then what happens?

BRIAN HESS: Exactly. Yeah, that's the risk. I think that's one of the bigger risks we're facing right now. Now, one market outcome we might expect to see if the economy were to weaken like that, or even if markets begin to price, it would be, maybe, a pause in the recent leadership from cyclicals. And the other side of that coin would most likely be a rebound in large cap growth. And maybe the Mag Seven names.

So I guess is this something we're expecting and willing to position for? Do we think maybe it's time for a pause in this cyclical move we've had over the past several months?

JACK JANASIEWICZ: It certainly seems like it. When you look at the performance of the cyclical components of the sectors within the S&P 500, from a return perspective, they're getting a little bit stretched, and that seems to be somewhat of a consensus trade. And so as we start to, maybe, get some data going forward here, that starts to show a little bit of a softening.

Wouldn't be surprising if we see a rotation where the market moves back from the value cyclical components more to the growth components. Because as growth becomes scarce, market bids up scarcity, which is going to be the growth complex. I don't want to say growth is scarce, but it's certainly slowing, which means people are going to be looking for more opportunities to take on growth.

And we've seen a pretty significant repricing in the tech sector, whether it's the broad tech space or just the Mag Seven, you're pushing, in some cases, 20% to 25% D ratings there. And so I don't think those valuations are quite as demanding as they have been. And you're still seeing these guys put up decent earnings.

So it wouldn't be a surprise to us if we get a rotation back in the other direction here as we get a little bit of more uncertainty there and the defensive names, in particular, maybe the Mag Seven start to, again, act a little bit more as a defensive proxy, which we've seen in the past, them act that way and that growth complex starts to maybe come back as leaders going in, in the near term.

BRIAN HESS: In case anyone is not quite sure what we're talking about when we say cyclical sectors, it's small caps, maybe materials. What other areas would you classify as in that cyclical category?

JACK JANASIEWICZ: So you'd think industrials, to a lesser extent, financials get lumped in there. Energy can get thrown in there as well. And then to your point, again, small caps tend to lump in there as well.

BRIAN HESS: Those were the high degree of sensitivity to changes in momentum in the economy.

JACK JANASIEWICZ: Correct.

BRIAN HESS: Now, if we do get a pullback in this part of the stock market, are there any areas where you'd view it as an opportunity to add? This is my last question. We're going to end here with a big one. So which ones are on the watch list for this-- could be a medium term opportunity, where we want to take advantage.

JACK JANASIEWICZ: Yeah, and we just talked about it. I think there's opportunity in, potentially, looking back to that growth trades coming to the forefront. I think overseas, there's opportunity to take advantage of the Japan story that we just walked through. In the models, we had actually taken a little bit of a profits in the emerging markets space.

We're still optimistic on that. We still have a positive outlook on that. It was just profit taking. Some of these areas have corrected, and they're back to looking somewhat attractive to us. So we start looking back at, for example, adding back to Latin America. So there's opportunities in there.

And again, we talked a lot about risks in this podcast. We're still genuinely optimistic here. We're just noting the potentials of how this could go wrong. And instead of looking to actually get rid of positions and de-risk, so to speak, we're just going to shuffle the deck and take advantage of opportunities that have changed over the last couple of weeks here, given the Iran backdrop.

BRIAN HESS: That's great, Jack. Thank you. I like that. So let's leave it there for this month. It's a busy week around here. We have the annual rebalance for our models. But that means next month, we can update listeners on the changes we've made to our allocations, connect the dots between our macro outlook and portfolio positioning. So thanks very much.

JACK JANASIEWICZ: Sounds good.

BRIAN HESS: See you then.

JACK JANASIEWICZ: All right. Sounds good.