By the end of last week, characterised as turbulent even by recent standards, some semblance of normalcy had been restored. It appears, and we are keeping our fingers crossed, that the frail armistice between Israel and Iran, brokered by the US and which was preceded by a demonstration of its military might, has not been violated. The sell-off in the equity market made a handbrake turn at the beginning of the week, and so did the rally in oil.

Although the core US PCE index rose 2.7% in May, a tad more than anticipated, and despite Donald Trump putting the US-Canada trade talks on ice due to disagreement over digital tax (Canada rescinded the tax over the weekend), there is a growing conviction that US borrowing costs will be lowered, if not in July, then in September. This, in return, sent the dollar into a tailspin, also pressured by the President’s belligerent rhetoric towards the Fed chair. Economic headwinds are now a greater concern than inflation, hence the anticipated rate-cut-induced stock market rally, which was also supported by China’s pledge to the US to accelerate rare earth exports. Staying with the world’s second biggest economy, investors have taken note of its struggling manufacturing sector, which contracted for the third consecutive month in June.

When the perceived risk of disruption in oil production and flow in the Middle East region was dismissed, oil plunged. However, in the second half of the week, help arrived from an unusual participant, Heating Oil. It was partly responsible for the noticeable depletion in US commercial stocks, and middle distillate stockpiles also drew down in Europe and Singapore. The rug, nonetheless, was pulled from under this product on Friday. If, as OPEC sources insinuated and Reuters reported, the producer group does opt for another accelerated output increase of 411,000 bpd in August, global and OECD oil inventories will, in all likelihood, start swelling in the not-so-distant future, ensuring that every attempt to push oil prices higher will end in disappointment.

Prospect Theory

Reading through the sections on politics and the global economy in any national or international newspaper or magazine gives the impression that stock markets are in freefall and oil prices are comfortably above $100 per barrel. The war in Ukraine shows no signs of abating, and the ceasefire in the 2,000-year conflict in the Middle East is shaky—almost by definition. Beyond military conflicts, trade tensions also unnerve both investors and politicians, and the U.S. budget is being criticized from several directions.

Recession—or worse yet, stagflation—cannot be ruled out, and it is notable that the two geopolitical hotspots are situated in significant oil-producing regions. Yet, equity markets are reaching new all-time highs almost daily. This optimism does not appear to be an impromptu adrenaline rush. Expected earnings of companies in the S&P 500 index for the next 12 months stand at $263 per share, slightly higher than the level before Liberation Day. Oil, despite the conflicts in Ukraine and the Middle East—regions accounting for roughly 32 million barrels per day of production—has dropped $13 per barrel, or 15%, in the space of a week.

Whilst this nonchalant attitude towards risk might seem perplexing, it can be explained away by the remarkable ability of investors to adapt to changing times. Or another way to put it, they expertly expose and take advantage of the divergence between political narrative and reality.

Take the latest market-moving event as a prime example. The initial market reaction to the Israeli bombardment of Iran, followed by direct U.S. involvement in the conflict through strikes on the Persian Gulf country's nuclear capabilities, and then an Iranian attack on a U.S. military base in Qatar, was a relatively brief sell-off in equities and a rally in oil. These trends quickly reversed. Curiously, all three parties—the U.S., Israel, and Iran—claimed victory, even though none achieved their objectives of destroying Iran’s nuclear arsenal, toppling its regime, or wiping the Jewish state off the map. These mutual claims of success led to the conclusion that, behind the belligerent rhetoric, there was little appetite to escalate the conflict. Investors quickly returned to equities and moved out of oil.

The alignment of investors’ attitudes with the new political and economic reality is what the so-called prospect theory, a behavioural economic model, seeks to explain. It describes how decisions are made under conditions of risk and uncertainty. Its most important concept is reference dependence: decisions are made by comparing potential outcomes to reference points, which are often based on expectations. The new norm-shattering U.S. President has certainly shifted the goalposts against which potential outcomes are measured. Mr. Trump’s policies, however controversial or even damaging they may seem, have not rattled investors’ confidence because they remain, for now, at the level of rhetoric. In the past, sabre-rattling foreign policy would push investors toward safe-haven assets. Now, with the reference point shifted relative to previous presidents, decisions are made in relation to this new norm.

A similar phenomenon is observed on the economic front. It was striking to see that late last week, equity investors stayed on the gravy train after the U.S. announced an agreement with China to expedite rare earth imports from its trading adversary. While the thaw in relations is a welcome development, the fact that current U.S. tariffs remain at around 16%—the highest in 90 years—has been conveniently ignored. Or rather, it has not been dismissed entirely, but it is not currently being given much weight. The outcome of the trade war is still uncertain, whereas the rare earth agreement is an explicit fact.

This new reference point—Trump’s volatile decision-making, that is—offers plenty of upside potential. Market dips triggered by headlines, social media posts, or press conferences are being seen as buying opportunities. Investors are placing their trust in hard data rather than second-guessing unpredictable policy outcomes. It is therefore unsurprising to see bond yields dropping sharply after the post-Liberation Day rally. Inflation concerns are fading, as are fears of recession. The U.S. economy is seen as just as resilient as it was before April or toward the end of the Biden administration. (It is not.) Sentiment will shift when uncertainty gives way to real, tangible economic risk—when the reference point moves once again.

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