Market sell off – What’s going on?

The inauspicious start to Q2 has continued, this time with a large decline in European shares at the end of this week. European stocks are a sea of red, with the heaviest declines for Italy’s FTSE MIB, the Eurostoxx index and the Dax. The move follows sharp declines for US stocks, as the rise in the oil price pushes Brent crude above $90 per barrel and WTI above $86 per barrel.

Stocks look set to register a negative weekly performance, with the Dow Jones currently down 3% so far this week. The Nasdaq and S&P 500 are both down approximately 2% so far this week. In Europe, the losses have been less steep, notably for the FTSE 100, which is holding up the best in Europe so far on Friday and is down 0.6% so far this week.

Iran/Israel risks fuel risk off tone

The risk off tone to markets is driven by an escalation of tensions in the Middle East, after Israel said that it had increased preparations for a retaliatory strike by Iran after Israeli forces attacked Iran’s diplomatic compound in Syria earlier this week. Ever since the Israel/ Hamas war started in October, the bigger risk for geopolitical security and thus for financial markets, has been a war between Iran and Israel. The latest events highlight how tensions between the two foes are on the rise, which is reverberating through financial markets. While we don’t think that there will be an outright war between Iran and Israel at this stage, the proxy war is heating up, which is why the oil price is on the rise.

The rising Oil price and the Fed

The prospect of an Iran/ Israel war would send the price of oil well above $100 per barrel, in our view. Although we think that the risk of war is slight, the market is pricing in that prospect. Added to this there are supply concerns, as Opec + continues to limit production for its members. The price of oil has risen by nearly 20% so far this year. This is a significant increase that is already disrupting the disinflation trend in the West. The big risk for markets is that the rising oil price leads to the Fed and other major central banks pushing interest rate cuts further into the future. We are not there yet, as Fed chair Powell said that the latest data on inflation did not impact the chance of rate cuts. However, the market is already pricing out the prospect of rate cuts from the Fed this year, with 2 cuts fully priced and a high chance of a third currently priced in, which is slightly less than the Fed’s Dot Plot.

Energy market dynamics and inflation

There are some interesting dynamics in the energy market right now. On the one hand the oil price is surging and is one of the best performing assets so far this year. On the other hand, natural gas and electricity prices have fallen sharply. For example, the ICE Nat gas price is flat on the year and is close to the lowest levels for the last 12 months. This could limit the pass through to consumer price inflation for now, but if the prospect of tension in the Middle East reduces oil supply further, then we may see the price of other commodities rise.

Shell: Q1 guidance is strong, although Gas trading declines

On the back of weak gas prices, oil giant Shell announced on Friday that Q1 gas trading revenue would be lower than last quarter, although overall the Q1 guidance remains strong. Shell is managing to buck the overall market trend in Europe today and is higher by 0.18%. Overall, the UK’s energy sector is the best performing in the UK index so far on Friday. We expect the FTSE 100 to be better protected vs. other European indices due to the size of its energy sector and its defensive qualities, which could protect it from too much downside while markets are in a risk-off mode. We see the German Dax and the FTSE MIB as remaining under pressure for as long as the oil price remains elevated as they have a large proportion of energy-intensive manufacturing companies.

Payrolls vs commodity prices

While the US payrolls report will be important for market direction today, we now have another factor to consider: where the oil price goes next. The options market is biased to a higher oil price, however, if we see signs that the US will release more oil from its Strategic Petroleum Reserve, or if there are signs that Opec + could reduce production constraints in the coming months, which we deem to be unlikely, then the oil price may back away from recent highs. Geopolitics and commodity prices are once again stalking markets and could weigh on risk sentiment until these risks are reduced.