NEW YORK, March 3 - Financial markets moved unevenly on Tuesday as traders and investors reassessed the fallout from recent U.S. and Israeli strikes on Iran, increasingly worried the confrontation could persist and push energy prices higher for an extended period.
Concerns that shipping through the Strait of Hormuz - a critical chokepoint that carries roughly one-fifth of the worlds oil supply - could be disrupted have intensified the risk of an energy-driven inflation spike. That possibility has prompted portfolio rotations and a fresh look at how long central banks may need to keep interest rates elevated.
"While not much has changed fundamentally since yesterday, investors are growing anxious about the duration of the war and its impact on energy prices," said Joseph Tanious, chief investment strategist at Northern Trust Asset Management in San Diego. "The reality is setting in that a prolonged conflict could dampen global growth and re-ignite inflation pressures."
Stocks felt the strain. The S&P 500 fell 0.9% as oil climbed for a second consecutive day. Although the index recovered some ground from earlier drops, it touched its lowest level in more than three months during the session, and all 11 of its sectors posted declines, signaling a broad-based selloff.
Fixed income markets also reflected heightened unease. Global government bonds weakened before trimming losses as market participants tried to gauge how long the conflict might last. Volatility jumped as the Cboe Volatility Index, Wall Streets so-called "fear gauge," reached its highest point in over three months.
"The reaction has become more intense...theres no sign of a quick resolution," said Que Nguyen, chief investment officer of equity strategies at Research Affiliates in Newport Beach, California. "People are waking up to the fact that this is a lot more complicated than they assumed."
Investors are closely monitoring the potential pass-through from rising oil into consumer prices. Brent crude was trading around $81 a barrel, up from roughly $60 at the start of the year. Market-based inflation expectations moved higher: the five-year U.S. breakeven inflation rate rose to 2.503% late on Monday, a level not seen since February 11.
Economists at Goldman Sachs estimate that a sustained 10% jump in oil prices would lift the consumer price index - a key inflation yardstick - by about 28 basis points, underscoring how energy moves can quickly filter into headline inflation data.
Alongside the price action, traders have scaled back the odds of near-term Federal Reserve easing. Fed funds futures on Tuesday indicated a 56% probability that the central bank will remain on hold at its June meeting, down from a position in late last month when markets had priced in a greater than 50% chance of a cut for that meeting, according to CME FedWatch.
"The biggest issue that [investors] are trying to weigh gets back to the intertwining of inflation and interest rates," said Chuck Carlson, chief executive officer at Horizon Investment Services.
Not all market participants view the weakness as purely negative. Some managers said they were deploying cash accumulated from technology positions into areas they expect to benefit if global growth re-accelerates. "We are taking cash we raised from tech to aggressively get more positioned for a global acceleration of economic growth," said Eddie Ghabour, CEO of Key Advisors Wealth Management, whose firm has been buying emerging markets ETFs this week.
That buying appetite has not erased the immediate market stress. Despite the recent declines, the S&P 500 remained only slightly more than 2% away from its all-time closing high. Yet the market's resilience has prompted warnings that investors may be underplaying the geopolitical risk. "The markets resiliency suggests to me that investors might be underestimating the geopolitical risk," said Andrew Slimmon, senior portfolio manager at Morgan Stanley Investment Management.
Looking ahead, market participants said they will be closely following developments. "Were really still at the mercy of the headlines," said Kevin Gordon, head of macro research and strategy at Charles Schwab. "The potential for whiplash in parts of the market is very high."
Clear summary
- Markets reacted to U.S. and Israeli strikes on Iran with a focus on how a protracted confrontation could lift oil prices and stoke inflation.
- Brent crude moved to about $81 a barrel, while the S&P 500 fell 0.9% and all 11 S&P sectors declined.
- Inflation expectations and Fed rate-cut odds shifted - the five-year U.S. breakeven rose to 2.503% and June hold odds via Fed funds futures stood at 56%.
Key points
- Energy markets: A potential cut to flows through the Strait of Hormuz - which handles roughly one-fifth of global oil - raised the prospect of higher oil prices and renewed inflation pressure.
- Equities and volatility: Broad equity selling pushed the S&P 500 to its lowest levels in over three months and sent the Cboe Volatility Index to a three-month-plus high.
- Fixed income and policy: Global government bonds weakened before recovering some ground; traders reduced the probability of a Fed rate cut by June.
Risks and uncertainties
- Duration of the conflict - markets remain uncertain how long hostilities could continue, which affects energy prices and growth-sensitive assets.
- Inflation pass-through - a sustained rise in oil could push headline inflation higher, as indicated by the rise in the five-year breakeven and Goldman Sachss estimate of CPI sensitivity to oil.
- Policy response uncertainty - evolving inflation and growth outlooks are changing expectations around the timing of Federal Reserve easing, creating potential volatility in rates-sensitive sectors.