Geopolitics in the driver’s seat

Markets have entered another week with geopolitical headlines as the major driver of price action, and with uncertainty running high, we think the likelihood of spreads revisiting their tights of this year has reduced.

Starting with the most obvious headline: No deal. While markets, and probably most politicians, were not expecting a spectacular breakthrough after the weekend’s talks between Iran and the US, we think it’s fair to say that the news at the margin was slightly worse than expected. The prospect of the US imposing a blockade on ships leaving the Strait of Hormuz not only boosted oil prices anew on Monday morning, it comes with the added complication that hurting the Iranian economy at this stage also deepens the problem of oil prices going higher. There is no detail at this stage about the mechanics of how this would work in practice, but there are already projections doing the rounds in the press of oil at $150 per barrel if implemented.

At time of writing, the reaction beyond oil prices appears muted. European high yield and investment grade spreads are 8bp and 2bp wider respectively, AT1s are around 0.5 points lower, and equities are down 0.5% and 1.3% in the US and Europe respectively. Government bonds barely moved initially but have sold off mildly into Monday afternoon. The subdued price action is likely down to the very fact that talks have taken place, showing there is some sense of urgency from countries involved to put an end to the conflict. It goes without saying that headlines might turn very bad, very quickly, and markets would follow suit. But it seems that after this first attempt at some sort of peace, the bar for a sharp sell-off has been raised somewhat.

Over the next few days market reaction might be led by whether the ceasefire holds or not. Notably, Iran has broadly respected the ceasefire despite Israel continuing to attack Lebanon, something that was in doubt as it had stated strikes on Lebanon had to stop before any negotiations took place. Beyond the next couple of days, markets will focus on tangible evidence of economic damage from the higher oil prices. So far, we have had higher inflation prints but there has not been much evidence yet of growth taking a hit, though this lag was always expected. How much could GDP growth be hit by? How will the global economies adapt to this shock? There are plenty of open questions now that still need to be answered.

This was not the only geopolitical headline over the weekend. There was a notable result in Hungary’s general election as Peter Magyar’s Tisza party won by a landslide, and it looks almost certain they will obtain the two-thirds supermajority in parliament needed for constitutional reforms. Domestically, Hungary is now more likely to receive currently frozen European Union funds. The new government could use its supermajority to reverse measures taken by Viktor Orbán’s government in recent years that have angered EU leaders, who have accused Orbán of attacking independent press and limiting judicial independence among other things.

On foreign policy, EU leaders will no doubt be cheering in silence (or perhaps out loud) as last year Orbán blocked a €90bn loan to Ukraine. There is hope in Brussels that the new government will reset relations with the EU, though it is worth noting Magyar’s party voted against the loan in the European Parliament. If the funds could now be delivered, it could bolster Ukraine’s defensive efforts and increase its leverage in any negotiations with Russia.

If these headlines were not enough, last Friday there was a meeting in Beijing between Xi Jinping and Cheng Li-wun, leader of the KMT-Kuomintang, Taiwan’s largest opposition party, the first such meeting in close to 10 years. Xi Jinping’s government has cut off most of its official communication channels with the island, after the DMP – Democratic Progressive Party won the elections in 2016 as they are regarded as separatists by Beijing.

On the back of the meeting, China rolled out a package of 10 policies and measures that are, at face value, positive for the China-Taiwan relationship. Areas included in the new policies are tourism, travel, and infrastructure. The policies were met with scepticism by the Taiwanese government, which called the measures a charade. It believes China wants to show it is acting as a peaceful neighbour, while the real intention is a complete unification against the will of the Taiwanese people. We expect headlines about the aftermath of the meeting to continue to flow through.

Geopolitics continues to drive market sentiment, with events in the Middle East in the driver’s seat. But it’s worth keeping an eye on developments around the world and the interaction between them. Hungary’s election, for example, could impact how Ukraine and Russia might, or might not, seek to end their war.

When it comes to spreads, we think that while corporate fundamentals remain solid, the balance of upside vs. downside remains somewhat skewed, with a rally likely to be relatively small if things go well compared to a larger sell-off if things do not. We continue to focus our exposures on higher quality credit, while having a reasonable amount of liquidity to buy credit if spreads do widen from here. But we believe it is unlikely spreads revisit the lows of a couple of months ago given that tail risk has ramped up.