The Art of a Measured Retreat?

We continue to closely monitor developments in the Middle East. At the time of writing on 11 March, the situation is still volatile, making firm conclusions difficult, but here is our current assessment.

Firstly, as each day passes it becomes increasingly unlikely that this can be viewed as a 'surgical strike' akin to the action taken in Venezuela. Some geopolitical strategists had believed that the US had picked a continuity candidate in advance (much like Delcy Rodriguez), and that once the senior leadership in Iran had been killed, a peace agreement would follow with a more US-friendly new administration. The developments over the weekend of 7-8 March, and the announcement of Mojtaba Khamenei as new supreme leader, suggest that these ideas are wide of the mark.

Secondly, many strategists took it as read that the primary reason for regime change in Iran was broader access to Iranian oil for global markets. US President Donald Trump's actions frequently betray his true motivations – to bring down the price of oil over the long term and reduce the cost of living in the US. His volte-face on Monday evening to talk down oil markets in the short term is further evidence of this.

Where does this leave us?

Right now (although this will likely have changed by the time you read this), these two conclusions suggest the most likely path forward is another version of TACO (Trump Always Chickens Out), or at least a measured retreat. The US can present this as a win ('so much winning, quicker than expected' and so on) and given the level of destruction of Iran's military capabilities and senior leadership, there would be some truth in that position. Iran might also see a gradual de-escalation as a win given the weakness of its current position. Longer term, this solves relatively few of the structural geopolitical problems in the Middle East, although one would be forgiven for believing that war was the wrong approach to achieve this anyway, given the history of the region.

Perhaps the most telling aspect of this conflict has been the market response. Equity markets are slightly lower, primarily driven by concerns over the cost of oil and gas and the knock-on risk of inflation. None of the equity moves in March so far have felt panicked. Bonds were also lower during the first week of March, before both equities and bonds rallied on news of a possible reduction of hostilities. Equities and bonds becoming correlated on daily moves is in line with the usual inflation playbook.

One concern at a time

This is also another example of the market being able to focus on only one concern at a time. Behind the geopolitical noise, the US had followed through on its threat to impose sweeping 15% tariffs following the Supreme Court judgement against specific tariffs earlier this year. And concerns around the weakness of private credit exposures through pooled structures such as business development companies (BDCs) appear to have quietened.

For investors, these types of markets are frustrating. Even those with 'correct' positioning often find themselves reducing risk to right-size exposures to increased uncertainty, and the skittishness of intra-asset correlations can make portfolio management difficult. Add to this those who have lost money in the process of reducing risk and the net effect is deleveraging, which leads to further small losses across the active management industry. Crowded positions are typically the most painful, as witnessed this month with the outperformance of crowded short indices and the negative returns to cross-sectional momentum factors. Often one must wait for the dust to settle and for arbitrageurs to re-enter trades for these dislocations to close.

At the risk of sounding like a broken record, there is value in liquidity in markets such as these, both for managing risk and capitalising on opportunities. The situation in Iran is evolving rapidly, and while forecasting is difficult from here, we expect the situation to ease over the next few weeks as both sides seek to avoid a prolonged conflict.

On the radar

The immediate focus is, hopefully, on the resolution of the conflict in the Middle East and the impact on energy prices. Concerns over inflation are expected to feed through into the correlated behaviour of equities and bonds, with both likely to come under pressure if inflationary concerns persist.

Over the medium term, the focus returns to the health of the US economy and its knock-on effects on credit markets. Non-farm payrolls (NFPs) at the end of February were a significant miss, and the long-term chart of NFPs is now showing a worrying downward trend.

Looking towards the end of the year, we continue to focus on the US midterm elections, and any actions the current administration may take to shore up support as we approach the polls.

All data Bloomberg unless otherwise stated.

Author: Adam Singleton, CIO External Alpha at Man Group. This edition of Views from the Floor is an excerpt from Adam's monthly The Early View column.