Middle East Tensions Gave Aerospace Stocks A Lift On Thursday, But Volatility Now Easing

It’s been a quick comeback for the S&P 500 Index (SPX), which hit new record highs Thursday and sits more than 8% above its early-June low. The index rose every day so far this week, though it shows signs of flagging early Friday as tensions in the Middle East remain in the picture.

It wouldn’t be all that surprising to see some unusual market movement around the open and close. That’s because In addition to all the geopolitical jitters, today is quadruple witching, which happens once a quarter as contracts for stock index futures, stock index options, and stock options all expire. This can sometimes trigger a rush to roll over risk and unwind baskets of stocks or futures.

Other than that, any headlines about tariffs or the Middle East are likely to take the day. The market got a scare Thursday when Iran shot down a U.S. drone, and stocks pulled back quickly from their big early gains. However, tensions over the incident seemed to defuse slightly as the day continued, and volatility—which rolled to strong gains at one point—stepped back a bit later on. 

How worried are market participants early Friday about the Iran situation? Well, judging by how the Cboe Volatility Index (VIX) is still below 15 after approaching 16 yesterday morning, not too much. Still, the market has a slightly negative tone Friday morning as it looks like a bit of profit taking might be at work.

Old Record High Breached

The SPX closed above 2950 for the first time yesterday and broke the old intraday high of 2954 set back on May 1. It was an impressive move, powered by some of the “cyclical” sectors that tend to do better in a growing economy.

Those include Energy—which got boosted by crude’s big rise as tensions grew between Iran and the U.S..—as well as Industrials and Technology. The Industrials and Technology sectors have both outpaced the broader SPX this week, maybe a good sign that cyclicals are coming back after so-called “defensive” sectors like Utilities and Health Care led the way previously. It also might be a good sign that the rally yesterday came with above-average volume, meaning heavy participation.

While this week’s (and much of this month’s) rally seems to rest on hopes for a rate cut, a hypothetical question might be in order for many people excited about this rate-based move: Why is the Fed considering a rate cut? It’s not because the economy is improving. St. Louis Fed President James Bullard was out there Friday morning saying he believed weak inflation and uncertainties about economic growth outlook warrant a rate cut, Reuters reported, but that’s not too surprising considering Bullard is a well-known dove.

Other Fed speakers also are scheduled today, but it doesn’t seem too likely that they’d be able to move the market much after everyone just heard the big picture from Fed Chair Jerome Powell on Wednesday. It does appear that the Fed Board is leaning more and more toward a rate cut. The futures market sure sees it that way, projecting 100% odds of at least a 25-basis point easing next month. The market shows 30% odds of a 50-basis point cut in July.

Geopolitics Takes a Back Seat, But Big Week Looms

For months, worries about the U.S. trade relationship with China dominated Wall Street. That hasn’t gone away, but this week the focus shifted squarely from west to east as pressure built in the Persian Gulf.

At this point, it’s unclear how much the situation will heat up, but the White House seemed to ease tensions when it hinted that the drone downing might have been a “mistake.” While stocks didn’t seem too perturbed by the situation Thursday after their initial pullback, crude oil appeared to get a big lift. All of this could potentially bring more volatility as investors watch where things go over the next few days.

Markets tend to dislike uncertainty, and Iran isn’t the only uncertain situation right now. Next week’s G20 meeting between President Trump and Chinese President Xi looms large, and so does the OPEC meeting next week. Without much in the way of earnings right now, the market is exposed more than usual to day-to-day geopolitical headlines, and that can make for choppy trading. 

Many people remain nervous about the China trade situation, and these things tend to take longer than many had thought to sort themselves out. Next week’s meeting isn’t a signing ceremony. It looks like a lot more work might be ahead.

Getting Technical and Watching Slack

This is the third time in the last year that the SPX has launched itself above the 2930 level. It’s unclear if this will be the time it manages to stay there, but it fell pretty quickly the other two occasions. Technicians say 2960 could be a level to watch, and that a close or series of closes above that would possibly be a strong signal of three times being the charm.

In corporate news, it looks like Slack Technologies Inc. WORK picked the right day for its direct listing. Shares of the newly public company shot up nearly 50% on its first session of trading Thursday, apparently benefitting not just from excitement about the company and its products, but also from the overall positive atmosphere surrounding Wall Street debuts and from the rally to a new record for the stock market. 

Many of the high-profile recent Initial Public Offerings (IPOs) are up double or even triple digits so far. Slack’s debut seemed to indicate that a direct listing can stir as much excitement as an IPO, at least this time. Also that the public continues to have a huge interest in newly public companies.

Semiconductors were one area that didn’t really participate in Thursday’s rally. One day doesn’t mean much, but that might be worth keeping an eye on over the next few sessions as the G20 approaches. Semis’ fortunes are pretty closely tied to trade with China. Other companies with China exposure have done pretty well since President Trump announced the coming meeting with President Xi. Boeing Co BA shares rose again Thursday, and so did Caterpillar Inc CAT.

The Fed meeting this week kind of pushed some of the date releases to the sidelines, but today offers more numbers with May existing home sales.

Figure 1: BACK ABOVE THE CLOUDS: It’s been a stormy three months for the S&P 500 Index (SPX), as this chart demonstrates. It’s gone from all-time highs to four-month lows and back to new all-time highs again. The question is whether it can stay long at these lofty levels. Data Source: S&P Dow Jones Indices. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

Greenback in the Red: After the Fed sounded dovish on Wednesday, the dollar index fell nearly 1% over the next 12 hours. This retreat comes after the dollar galloped to nearly two-year highs earlier this spring amid global economic worries that seemed to lift demand for so-called “defensive” assets like gold, Treasuries, and the greenback. Gold also recently hit a nearly six-year high, and as we’ve seen, 10-year Treasury yields fell below 2% this week for the first time in two and a half years.

Now the dollar now appears to be playing defense in the wake of the Fed’s words, falling to well under 97 on Thursday from highs above 98 less than a month ago. The softer dollar—if it lasts a while or falls further—might be good news for U.S. firms that depend a lot on overseas revenues, especially Industrial and Technology companies. A muscular greenback has hurt their earnings a bit recently, but lower rates might mean some relief, along with a possible boost to overall S&P 500 earnings per share growth. Still, let’s not get ahead of ourselves. The dollar would have to probably fall below 95 and stay there for a while to start having a major positive impact on earnings for multinationals.

Watching “Risk Assets” As Middle East Worries Percolate: On the other hand, if tensions grow in the Persian Gulf, the dollar might possibly be a beneficiary. An international crisis often sends investors fleeing into areas of the market they see as “safer,” though no investment is truly “safe.” This can sometimes include the dollar, the Japanese yen, gold, and U.S. Treasuries. Treasuries have already rallied fiercely over the last six months, but with 10-year yields falling below 2% this week for the first time since November 2016, it’s unclear how much runway the Treasury rally might have left. Gold hit $1,400 an ounce this week, a level it last touched in late 2013.

If tensions grow over the weekend, it’s probably worth watching gold and the dollar, as well as crude. It goes without saying that crude is the main market indicator of stress in the Middle East, and its sharp rise Thursday offered more evidence of that. Volatility—another so-called “risk” meter—also started to see some bidding, with the Cboe Volatility Index (VIX), up 7% by midday Thursday to near 16 after falling below 15 earlier this week. That’s still below the historic average for VIX, but some investors who hadn’t bought VIX futures in a while apparently started to find them interesting again this week. However, VIX pulled back later Thursday to under 15 again when it looked like tensions in the Gulf might be defusing slightly.

Defense on Field: The aerospace and defense sector, led by BA, Raytheon Company RTN, and Lockheed Martin Corporation LMT took a ride up the escalator, climbing 1.2% Thursday as tensions with Iran ramped up. LMT and the others have performed well lately, though some of that might reflect the weaker dollar as much as any geopolitical worries. These companies tend to be barometers of military spending, so any international touchpoints can give them a boost. Then there was the recent announcement of a planned merger between United Technologies Corporation UTX and RA, which raised hopes for more merger and acquisition activity in the defense sector. The next key date in the Iranian situation will be July 7, Barron’s reported. That’s when Iran will decide if it continues to go by the terms of the 2015 nuclear deal, which President Trump exited.

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