Markets may be underestimating the risk of rising inflation as the escalating Middle East conflict disrupts energy prices and global trade, says Alex Morris, CEO of F/M Investments.
Speaking to Trader TV, Morris discusses the market signals suggesting how long the war could last, as well as the potential short- and long-term implications for global markets. He also examines the impact on capital flows, market liquidity, and retail trading activity.
In the episode, Morris shares his views on how trading desks can protect portfolios and the dilemma central banks face as their fight against inflation intensifies.
Interview
Josephine Gallagher – The conflict in the Middle East and the wider geopolitical situation is evolving very quickly, but one of the big questions is, how long it will last? What are the short and long-term implications of this conflict?
Alex Morris – It is certainly rapidly evolving. It started quickly, and I don’t think anyone really knows when it’s going to end, particularly the people who are helping wage it. So we have to now look to markets to kind of decide how do we react to that. It’s important to remember a stock market is an expectation market, so that’s probably our best view into the future. The oil market is a right now kind of market, so we almost have to put that bit aside. But if we do blend them together and try to see what they’re both telling us, it seems like this is an April, probably Easter, sort of all said and done, at least that’s what the market is pricing at this point. But that’s based on what the market is expecting, hoping, wanting to happen. There’s no actual geopolitical concept behind that. Now, what does that mean longer term? Well, sort of safe haven, Middle East, things that Dubai and Abu Dhabi, a handful of other placement building probably starts to go away. Some of that capital that had been locally invested starts to probably go abroad as it seeks a better return and is no longer able to attract talent to it. But we also start have to look at what’s what is going to happen to global shipping patterns, and what that means for long-term investment trades in general, including some of the EM (emerging market) but also in particular, the commodities complex that is about to be rocked a bit.
Josephine Gallagher – And just to get a little bit more detail from you, what has been the impact on market liquidity?
Alex Morris – Liquidity has remained fairly strong. I think the price changes you’re seeing now are true supply and demand and sort of point of service, particularly in the oil world. Oil VIX, more than tripled, hit above levels we saw when oil went negative in 2020 during Covid. But the market has pretty well absorbed it. I think the general liquidity of the market had been very high, very strongly. There had been a lot of cash sitting on the sidelines that allowed this to happen. So we haven’t seen any strains or breaks yet. Now, if we stay above $100 oil for a sustained period of time, you might start to see some cracking as the futures market that gets three or four contracts out now starts to have some liquidity issues.
Josephine Gallagher – So the retail space tends to be a bit more reactive when it comes to big macro events. So what have you seen in terms of retail activity?
Alex Morris – Retail Investors have, on the whole, held their nerve pretty well. Equity markets haven’t had dramatic changes, certainly relative to ‘Liberation Day’ almost a year ago now, when changes were very dramatic. Retail investors do seem to be playing around in commodities a bit, sometimes through leveraged ETFs (exchange traded funds), which tends to be their want. We do see some changes in volume of futures and options, particularly in commodities, which we expect, but a lot of that’s institutional volume as well that’s positioning themselves, particularly natural consumers of those. But on the whole, retail investors haven’t done much now. Retail Investors have been hoarding cash for a long time. They’re still doing that, and not at a dissimilar rate, but they also came in to buy the dip when that happened, and seem to be fairly content with long-term asset allocation positioning rather than tactical tweet by tweet positioning that we might have otherwise expected two or three years ago.
Josephine Gallagher – Understood. What are some of the biggest risks that investors are miscalculating or underestimating right now?
Alex Morris – I think the one that’s most pressing, because we just got Michigan’s inflation expectations, is indeed inflation. For the first time we seem to come under inflation expectation, which feels like a great time to realize inflation risks are being mispriced in the market. Inflation is coming. We are going to see some pull through to CPI (Consumer Price Index) because oil is very volatile and up, and that is going to make its way to the numbers. That number does seem to be coming down six months out, if we look at the oil futures market. But realistically, there’s a lot more that can go wrong to keep oil prices high, particularly restocking strategic reserves across the globe that are being emptied now to help stabilize the oil price, as well as just a general ability for this to happen again, which I think investors are mispricing. That’s also true for other commodities that are going to be impacted by shipping disruptions, energy price disruptions, and that does have a knock on effect to commodities, transit costs, that has knock on effect to leisure travel and other items so as well as general trend that we hadn’t actually whipped inflation in the US or the ECB (European Central Bank), and it’s still likely to come. If we look at break-even rates. The US, break even rate is up 25 to 30 basis points over the last few weeks. That number is two to three times that for ECB countries and the UK. So I think inflation is misunderstood in the current environment, and like to continue to be misunderstood until we get a few screaming hot prints that remind people inflation is a generational issue, and you have to beat it once and for all. You can’t just hope it takes care of itself.
Josephine Gallagher – As you mentioned, there is a big risk of inflation ticking back up now. How concerned should we be about central banks having to also increase interest rates?
Alex Morris – Well, we were always concerned about inflation, I think even more so than the average investor and trader had been. So this isn’t new to us, and we’ve been positioning for this. The central banks have an interesting conundrum. Now, given labour market dynamics, they want to cut; they were looking at two cuts this year. Now the Fed futures market is for at least the US. The Federal Reserve is saying no cuts this year, maybe no cuts until June of 2027, good news for traders. Fed fund futures are almost always wrong in these reactions, but it’s a good barometer to see that we went from 100% certainty of two cuts this year to none in more or less a week. I think central banks have a tough row to hoe here. We know we probably do need to cut rates, but we’re going to see a stagflationary environment where doing that is going to be particularly hard, and amongst novel pressure from at least in the US, the executive branch, to weaponize monetary policy at the Fed to affect outcomes elsewhere in the government. It’s going to be a very interesting few months as we work through this. But I think the pressure to lower rates will outweigh the pressure of even the economic theory to raise them. That might be just a bridge too far.
Josephine Gallagher – And finally, how can investors on trading desks protect against these short-term shocks and long-term inflationary risks?
Alex Morris – Well, I don’t think we should just pull out of all of our risk assets now. This might be a good time to stop allocating to them, and going to cash is the natural and good reaction to that, because our goal isn’t to neuter our portfolio return. It’s to provide some ballast to it in these times of uncertainty. So as we go to cash, we want to buy some inflation insurance. We think that’s going to be a risk that we need to look after. So let’s buy something in the short-duration tips market and the linkers market. We don’t want duration to cannibalize all of the inflation insurance we just bought. Separately, we also want to take some duration in the nominal market. We’re getting high rates there. Even if rates go up a bit, we’re going to be compensated to do those roles, and when rates do come down, which it does seem we are poised for at some point, we want to benefit from that down trade. And that sort of combination gives you enough safety and security where you don’t have to worry about credit risk, you don’t have to worry about pure equity risk, that we think we’re getting a fair balance of risk management and compensation with also having that nice ballast where if things do get worse, we’re not going to be hurt as much.
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