Halo, World!

The rise of the software sector saw its humble beginnings in the form of the simplest of programs, where the engineer would write a simple code which output “Hello, World!” onto the screen. Over time, Software Engineers have continued to build and write innovative codes that have helped to handle a multitude of tasks more efficiently. As the industry evolved, investors awarded the software companies with high valuation multiples given the nature of their business models which are light on assets, high on growth, and have higher returns on equity. Lately, with the advancements in Artificial Intelligence technology, the software industry has found itself in a tailspin. As AI technology can now write software codes quicker and with less errors; investors are fearing that the moats around the business models in the industry have started to erode and are closely scrutinizing the durability of several of these business models in the industry. As concerns mount, investors have indiscriminately rotated towards areas that are heavy on assets and low on obsolescence, a trend now popularly known as HALO (Heavy Assets, Low Obsolescence) trade amongst investors.

As the software sector is navigating through a challenge of the new Halo World, which dominated most of trading during the month of February; sectors such as Energy, Materials, Real Estate and Consumer Staples have benefitted. Consequently, Energy and Materials sector heavy S&P TSX was in green by ~+7.7% during February as compared to the Technology sector heavy S&P 500 Index, which was down by -0.80% for the month. In addition to the Halo trade, rising geopolitical risk premium as tensions had continued to simmer between Iran and the United States during the month alongside growing arguments for depreciation in the US dollar also led to the appreciation in Gold and Crude Oil prices, further favoring the outperformance of Canadian markets. The last day of the month witnessed the United States launching a military operation on Iran with an aim to change the regime and destroy its nuclear and military capabilities. The immediate reaction was that of a spike in crude oil prices. Gold prices, which historically have served as a haven in times of geopolitical uncertainty also advanced initially, however, have been on a decline shortly after the initial gains.

Historically, the impact of war on stock markets have been short lived and as soon as investors sniff an off-ramp and/or a diplomatic solution, the losses are swiftly reversed by markets. With about two weeks into the conflict and no sign of an off-ramp or a diplomatic solution yet, we think the markets are increasingly discounting the possibility of a few more weeks of disruption. The frequency of attacks from Iran had decreased, which could be due to running low on ammunition, destroyed military infrastructure for launches and/or perhaps a strategic play to use less ammunition and prolong the conflict. The longer the Strait of Hormuz stays closed, the higher the economic cost on the rest of the world, and therefore pressure on the United States to find an off-ramp from the conflict. Given that approximately 20% of the world’s oil supply passes through the Strait of Hormuz, the crude oil prices have jumped ~50% since the start of the conflict (See Figure. 1) owing to disruption in supply. A drawn-out never-ending war could mean the crude oil prices stay elevated and increase inflationary pressures in the global economy. This will complicate the tasks of the Central Banks which were beginning to become comfortable with somewhat still elevated but largely stable inflation rates. Bond yields have jumped on both sides of the border on expectations of more inflation in the coming months, which we think is part of the reason for appreciation in the US dollar index and therefore a decline in gold prices.

Figure. 1: Crude Oil, WTI Active Contract

Source: Bloomberg

The latest CPI (Consumer Price Index) inflation of +2.3% in Canada for the month of January (reported in February), was below the expectations of +2.4%; and +2.4% in the United States for February (reported in March) was in line with expected +2.4%. However, these numbers are stale as they represent the prices before the start of war in the middle east and a spike in crude oil prices. The unemployment in Canada jumped to +6.7% in February from +6.5% in January and in the United States to +4.4% in February from +4.3% in January. Rising unemployment along with potentially increasing inflation suggests the chatter around stagflation and perhaps even a recession (if the war prolongs for longer) could increase in the coming months. That said, we think the Trump administration is not oblivious to this and would not like to approach mid-term elections with a spectre of stagflation or recession looming large. Overall, in our opinion, incentives exist on both sides to find an off-ramp from the current situation but will likely be sought only if they have something to show to their respective supporters back home.

A de-escalation will lead to a swift recovery in the markets. We, therefore, maintain our constructive outlook for the year as we think that though the geopolitical developments and macro economic data provides a reason increase the caution, it does not point towards a need for change in stance yet. We think still positive corporate earnings amid the narratives of AI disruptions, fluctuating geopolitical risk premiums, and changing macro-economic environment bring about risks as well as pockets of new opportunities for now.

Source: Bloomberg

Vipul Arora is a Portfolio Manager with CI Assante Wealth Management Ltd. The opinions expressed are those of the author and not necessarily those of CI Assante Wealth Management Ltd. Please contact him at 613-258-1997 or visit ofarrellwealth.com to discuss your circumstances prior to acting on the information above. CI Assante Wealth Management Ltd. is a member of the Canadian Investor Protection Fund and the Canadian Investment Regulatory Organization. Insurance products and services are provided through Assante Estate and Insurance Services Inc