Binary Outcomes

Energy markets, particularly oil, have produced some of the great supply and demand lessons that feed our understanding of economics. This one is no different. My first lesson came in the early 1970’s when I could only buy gas on odd numbered days (because my license plate ended in an odd number). I was one of the lucky ones because it meant that at the end of some months, I could buy my allotment of $10 of gasoline 2 days in a row. The U.S. was in the throes of a great supply shock with dramatic consequences. Inflation, which was already becoming a problem, became materially worse as crude prices roughly quadrupled in a very short time frame. What is not as well remembered is that the embargo by OAPEC, came on the heels of the Yom Kippur War in reaction to U.S. efforts to supply more military aid to Israel. With the embargo, the Arabic states flexed their economic muscle for the first time and caught the U.S. as domestic oil production was in a structural decline. It was a difficult lesson, indeed.

The U.S., which was still primarily a manufacturing economy and highly dependent on oil to drive that economy forward, was hit hard as inflation persisted and growth slowed to a crawl – a classic case of stagflation. From a purely economic perspective, the question today is whether we are headed for another period of stagflation – slow or no growth and elevated inflation.

How Long?

Since the start of this ‘excursion’ in Iran, the key variable has always been “how long this will last?”. If this war ends soon, regardless of who ‘wins’, markets can come back to normal within some reasonable time frame (months). However, both sides currently appear entrenched, and that risks the closing of the Strait of Hormuz becoming a continuing problem. The longer it lasts, the greater the risk of demand destruction (recession) and a longer, more difficult recovery at some point. The end game is unknowable.

Iran is outwardly very committed to a continuing war. The attitude is: If you can deal with $200 oil, keep at it, we are not going anywhere. However, in light of the continuing destruction taking place and the lack of support from neighboring Islamic countries, we have to believe that commitment is at least wavering.

President Trump, with midterm elections coming, is under increasing pressure to end this military operation or risk losing the midterms. Logic would dictate that it will be extremely difficult for the President to continue the conflict beyond a few more weeks. But he will no doubt want to make sure that Iran is not in a position to strike the U.S. anytime soon.

This is a classic game of chicken – holding on in hopes the other pulls the plug first. From our perspective, the implication is that the risk of this conflict continuing ‘too long’ is somewhat greater than the prospect of ending soon because each side tends to assume the other is weakening and each side projects that they only need to hold on a little while longer.

So far, the stock market has held up remarkably well, but that can turn on a dime depending on developments. Some of the more ominous possibilities:

• A ground invasion of Kharg Island. Kharg Island is the funnel that some 90% of Iranian crude exports flow through. A Wall Street Journal story indicates that operations on Kharg have enabled Iran to continue to deliver oil out of the Persian Gulf (mostly to China and India). A ground assault to stop that flow of oil (and money) to the Iranian government would be a serious escalation and one that would be substantially more difficult to end.
• Desalination Plants. There are also reports that desalination plants have been targeted. If there is a commodity more valuable than oil in the Middle East, it is water. Very high percentages of drinking water in the region (except Iran) are supplied via desalination plants. Attacks on these plants could have incalculable consequences and desperate times often lead to desperate measures.

One thing is certain, each day this conflict continues makes a recovery a little more difficult. Oil wells are not spigots that can be turned on and off easily. Barring a major escalation, we view the stock market as continuing a downward drift until a tipping point is reached in one direction or another. It’s all about time, and no one knows when time will be up.

If the war tips to a major escalation, it is likely to create some sharp market declines as a very real recession potential gets priced into markets. A longer war will tend to imbed inflationary impacts along with the economic slowdown. That is the stagflation scenario.

On the other side of the coin, any indication that Trump has had enough and backs off the offensive could send the market flying to new highs. If the war ends quickly, the inflation can be temporary and economic growth can resume more easily.

The market outcomes are essentially binary – up or down, and completely unpredictable. History has taught us that living through the turmoil and not attempting to time market moves is the rational thing to do, however unpleasant it might feel at the time.

Our view and advice to our clients is to stick to the plan. Diversification remains the armor that allows investors to stay invested.

Have a great week!

What We’re Reading

• The U.S. is running out of ways to get oil prices down. It is up to the military.

• How the Iran war could start to impact U.S. retail prices

• Concerns grow in private credit: What investors need to know

Palumbo Wealth Management (PWM) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where PWM and its representatives are properly licensed or exempt from licensure. For additional information, please visit our website at www.palumbowm.com.

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All information has been obtained from sources believed to be dependable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.

General News

By: Adam