Usual quarterly market lift offset by Israel ructions

Geopolitical risks dominate for now but the December quarter usually brings a positive return for Australian shares.

Israeli Merkava tanks positioned in the north of Israel. The conflict is raising uncertainty about global financial conditions. Picture: AFP

As global markets worry about potential geopolitical fallout from the Middle East crisis, it’s worth remembering that the December quarter usually has a positive return for Australian shares.

Since 2000, December quarter returns for the Australian sharemarket have been negative on just four occasions – or 18 per cent of the time – with an average return of 2.8 per cent.

So far this quarter, the ASX 200 has been restrained by the recent surge in bond yields and the outbreak of war between Israel and Hamas. The index slipped 0.4 per cent to 7026.5 on Monday.

While US CPI showed sticky services inflation and a US 30-year bond auction was disappointing last week, US bond yields were capped by the message from Fed officials that tightening financial conditions lessens the need for more interest rate rises.

Unless Iran is directly implicated in the attack on Israel, the Middle East conflict may not have a major impact on energy supplies, notwithstanding the fact that the price of European natural gas rose 47 per cent last week on mounting concerns about supply shortages.

With the Israel defence force poised to start a ground invasion of Gaza, it’s also worth noting that risk assets often rally when such invasions actually get under way. The rally immediately following Russia’s invasion of Ukraine was cut short by surging energy prices and aggressive US rate increases.

JPMorgan chief executive Jamie Dimon. Picture: Getty Images

But the current conflict is complicated by its potential to pull in both Hezbollah and Iran.

JPMorgan chief executive Jamie Dimon warned investors to prepare for higher interest rates, persistent inflation, and fallout from the violent conflicts in Ukraine and the Middle East.

“My caution is that we are facing so many uncertainties out there,” he said on a conference call. The war in Ukraine compounded by last week’s attacks on Israel may have far-reaching effects on energy and food markets, global trade, and geopolitical relationships,” he said.

“This may be the most dangerous time the world has seen in decades.”

After falling 8 per cent from late July peaks to early October lows, US and Australian sharemarkets appeared to anticipate the usual year-end rally, with sharp rebounds in the past two weeks.

But while the direct impact on financial markets from geopolitical conflict is typically short lived, macro impacts often linger. To some extent markets may worry about how upward pressure on oil prices might underpin core inflation and potentially prompt more central bank action.

“While policymakers will likely look through these developments in the near term, higher oil prices can work their way into core inflation and inflation expectations if sustained, demanding central bank action,” Principal Asset Management chief global strategist, Seema Shah said.

“The critical macro concern lies with the oil market reaction … a significant escalation in tensions would likely apply further upward pressure.

“Global economic growth is by no means immune, but the fall in global energy intensity in recent decades implies a smaller growth impact than in the 1970s. As a net oil exporter, US economic growth is also less vulnerable.”

Ms Shah noted that safe haven flows contributed to the sharp retreat in bond yields last week after the US 10-year yield hit a 16-year high of 4.89 per cent. But she said that if oil prices rose further and price pressures re-emerged, expectations of additional monetary action from policymakers could threaten to trigger a “renewed bond rout”, which would be bad news for equities.

“In light of the situation in Israel, it is prudent for investors to maintain a diversified portfolio across different asset classes, with a particular emphasis on high quality and defensives,” she said.

Still, other strategists are happy to take the other side of this view.

“Oil prices may rise, but investors should resist the assumption that this will lead rates higher,” Morgan Stanley macro strategist Michael Zezas said.

He said that while it might take several more steps of escalation to get there, oil supply disruption was “one possible outcome from the current Middle East crisis”.

Higher oil prices meant higher fuel prices, but the effects on inflation were “more muted and temporary”. In previous oil supply shocks, a 10 per cent jump in price on average added 35 basis points to headline US CPI for three months, but just 3 basis points to core CPI. And higher fuel prices can meaningfully crimp lower-income consumers’ behaviour, weakening demand in the economy.

“Hence, one shouldn’t assume higher oil prices translate to a more hawkish central bank posture,” Mr Zezas said.

Apart from the Middle East conflict and the outcome of central bank meetings in the coming months, investors now face the US quarterly earnings season.

BofA, Goldman Sachs, Tesla, Netflix, State Street and Johnson & Johnson will report this week.

The annual general meeting season and results from Australian banks are also in focus.

Higher interest rates and sound credit quality have driven strong earnings growth and a rebound in profitability for Australian banks over the past two years, but Morgan Stanley predicts challenging industry conditions, weak growth prospects and downside risk to consensus earnings estimates.