The Israel-Palestine war has been raging for nearly two weeks since Hamas fighters bombed Israel, and infiltrated cities and settlements.
This piece delves into the key developments on the ground; the response of national actors and organizations; the potential for more parties to join the war and the central role of Iran in scenario building; and most importantly for our readers, the potential impacts of the fighting on select assets, financial markets and the broader economy.
In particular, we look at the trend in equities including which sectors are likely to benefit or suffer from a prolonged war in the Middle East; shifts in treasury bonds and potential for change in policy rates; the crucial questions around crude oil, natural gas, and energy markets; the expected trajectory of the mighty dollar and other safe havens which tend to preserve purchasing power amid market chaos.
Finally, we discuss the broader economic outlook, as well as the approach financial market participants may consider following in such a fluid situation.
The Details
TL;DR
- Earlier this month, the Israel-Palestine war began without warning when Hamas fighters bombed Israeli cities.
- Diplomatic efforts by President Biden and Secretary of State Blinken to ease tensions in the region have not been successful.
- In support of Israel, the United States has moved military vessels into the region.
- Declines in equity indices so far may have been capped by expectations of largely localized disruption.
- The destruction of a hospital in Gaza on Tuesday, October 17th, has made any peaceful resolution in the near term virtually untenable.
- Moreover, investors and traders are jittery given the possibility of Iran, a major OPEC member being drawn into the fighting.
- In addition, Israel is expected to launch a full assault on Palestine at a moment’s notice.
- Tensions along the Northern border with Lebanon and Syria are beginning to rise, adding to the geopolitical uncertainty along with the threat of intervention by Hezbollah.
- Defense and energy stocks are likely to find strong support while travel and tech shares may be beaten down in the event of a prolonged war.
- Depending on the severity of the conflict, crude oil prices could stabilize around $93/barrel or surge to $150/barrel.
- To combat rising price pressures, global central banks will likely need to raise rates.
- Gold prices are poised to crack the $2,000 per ounce mark.
- The dollar is likely to continue to strengthen while geopolitical tensions persist.
- Alternative safe haven currencies such as JPY and CHF are likely to see increased demand.
- Financial markets are in a wait-and-watch mode as it remains unclear what the eventual scope and scale of the conflict may be.
The key piece: iran
Source: Macrobond; MarketWatch
Although a ground invasion would spell bad news for the global economy, the primary concern for financial market participants is the potential response of Iran. Israel and Iran have been bitter enemies for decades, and their ongoing conflict is one of the key reasons for the nearly perpetual turmoil in the Middle East. While Israel has been attacked by Hamas, the dominant political force in Palestine, the US state believes that this organization has been receiving active financing, training, and support from Iran. Most experts would agree that an even greater threat is posed by Hezbollah, an organization active in Lebanon and Syria, which share the Northern border of Israel. Hezbollah is believed to consist of highly-trained, well-armed, and battle-hardy troops, and as per US Intelligence is also primarily supported by the Iranian government. In support of Hamas, Hezbollah squads have begun to undertake aggressive operations against Israel, although these have not yet reached a fever pitch. This means that Israel must now be concerned about the possibility of attacks from both its Northern and Southern borders. In retaliation for an earlier engagement, Israeli forces recently destroyed a Syrian checkpoint, which has heightened tensions in the region and threatens to draw neighboring countries into the conflict as well. As a key OPEC member and the fifth-largest oil-producing country, markets fear that Iran may draw the ire of the United States and be subjected to a new round of sanctions that would choke its oil production and exports to the tune of at least 1-2 million barrels per day, effective immediately. Such a severe reduction could force significant tumult in the global energy markets and have serious knock-on effects on the wider economy, especially on the ongoing fight against inflation. Higher oil prices will inevitably lead to increased inflation and derail the ongoing effort of central banks to tame inflation.
Equities
As discussed above, markets have been able to maintain a semblance of calm while awaiting fresh developments. US stocks ended lower for a fourth day running, following a speech by Governor Powell that suggested that additional rate hikes may be required to combat stubborn inflation. The S&P 500 fell 2.4% over the past five sessions, closing at 4,224.16. With plenty of uncertainty in the Middle East, markets should expect heightened volatility, particularly in sectors that are tightly integrated with the region. Industries that are likely to benefit if hostilities continue include defence due to the rising demand for weapons, and energy stocks as oil and natural gas exports begin to dry up. At the same time, tourism is likely to suffer in the Middle East, as a result of which, hospitality and leisure, aviation, logistics, and potentially manufacturing stocks could see significant downside in the weeks and months ahead. In addition, tech stocks may take a hit, given Israel’s significant presence in the space as well as the possibility of surging oil prices. High oil prices tend to lead to higher interest rates which can dampen activity in areas such as tech.
Source: Reuters
The movement in equities will largely depend on the collective assessment of markets in relation to Israel’s planned invasion and the probability of the Israel-Palestine conflict spreading throughout the region.
Bonds
Bonds continued to bleed with the 10-year treasury yields which influence worldwide borrowing costs approaching 5% today. The sell-off comes amid robust consumption in the US economy despite the aggressive tightening of monetary policy over the previous year and a half. With oil prices expected to stay elevated, stickier inflationary forces are driving rate hike expectations and leading yields higher, which have already risen nearly 40 bps since the beginning of October 2023. However, momentum in yields could be capped by an uptick in safe-haven purchases, although the market is likely to remain in the vicinity of 5% for the time being.
oil
As per Anadolu Agency, collectively, the Middle East accounts for 48.3% of the world’s oil reserves, meaning that any adverse developments in the region are certain to impact global energy markets.
Source: NASDAQ
For instance, in the case of the Brent benchmark, prices closed at $84.58 per barrel on the eve of the Hamas attack, i.e., Friday, 6th of October, and were trading at $92.36 per barrel, amounting to an increase of 9.2% at the time of writing.
As discussed earlier, the uneasy calm in the financial and commodities markets is driven by the uncertainty around the US’s stance towards Iran; and the role other regional players are likely to assume.
However, such an environment may also encourage greater speculative action, further contributing to volatility in the oil markets.
What remains unknown is the extent and duration of disruption.
If the status quo is maintained in the war, Brent prices will likely continue to hover around the $ 93 mark.
In the event that Israel’s land invasion was to commence, oil would certainly climb to over $100 per barrel.
However, if Iran were to enter the war, a much larger regional conflict may be triggered.
The vital Strait of Hormuz, which accommodates 17 million barrels of oil each day, or approximately 20%-30% of global consumption may face restrictions from Iran, which will keep prices elevated and lead to a real reduction in supply.
Yet, the seeming reluctance of Iran to join the war may be driven by concern of US intervention, while some Middle East experts believe that even Hezbollah, though supportive of Hamas, is looking to establish itself as a wider regional power, and may wish to display only ‘symbolic’ support.
Cayler Capital’s founder and CIO Brent Belote expects that if the United States does engage militarily, prices will be pushed in the $110 – $120 per barrel range, or even higher.
However, Lord Meghnad Desai and industry experts such as Dan Alamariu, chief global strategist at Alpine Macro expect that an all-out war could push oil prices to above $150 per barrel.
It is crucial to note that at this time oil prices may be capped to a degree due to Israel not being a major producer-refiner of oil, the easing of sanctions on Venezuela, the roll-out of sanctions on tanker owners who transport Russian oil for above the agreed price cap of $60 per barrel, and US domestic production hitting an all-time high in the previous week.
For its part, Iran has called upon countries of the Organization of Islamic Cooperation (OIC) to stop supplying Israel in the aftermath of the Gaza hospital strike.
However, the US President and Israeli government claim that one of Hamas’s own rockets hit the hospital, while Hamas insists that Israel is to blame, with neither party ready to budge.
If, as expected, oil does rise significantly in the coming weeks, Saudi Arabia may have an incentive to adjust output to maintain elevated prices (at least above $100 per barrel) to reap greater rewards while also preventing an all-out global recession from occurring.
Yet, surging oil prices are certain to power higher inflation, drive higher rates, and skew national trade balances.
natural gas
Much like oil, gas continues to see upward momentum, which could prove to be very worrying for European consumers.
The European benchmark rose over 40% last week, marking a 7-month high.
Following the attack on Israel, gas prices increased by 5% on the day.
Amidst the chaos, a key Chevron-run gas field in Israel has been shuttered, which may exert pressure on prices in the future as well.
However, record inventories in European storage tanks will provide consumers with a much-needed cushion, particularly as winter approaches.
THE DOLLAR
Given that the monetary system remains a dollar-centric one, the greenback is considered perhaps the safest and most liquid of all assets.
If oil prices continue to rise, and inflation begins to re-emerge across the world, central banks will need to respond by tightening rates.
In such an environment, the US’s unparalleled perceived safety means that capital outflows from emerging markets shall race to the security of US holdings, further strengthening the dollar.
Bernard Baumohl, chief global economist at The Economic Outlook Group believes that even if US interest rates have peaked, its relative attractiveness compared to Europe will ensure that demand for the dollar remains strong even in an environment where “interest rates go down.”
This is particularly likely given the resilience of the US economy and continuing labour market strength versus the turmoil in the German market and other leading countries.
Alternative safe havens
Other than US treasuries, alternative safe havens are expected to perform well while geopolitical upheaval persists in the Middle East.
For instance, gold is up 5.7% on the week, while the more temperamental silver has increased by 5.6%.
In fact, during the last week, the yellow metal experienced its best week since March 2023, i.e. since the US’s regional banking crisis and the fallout from SVB and other banks.
Although bullion prices will ease if policy rates are increased by central banks, the potential for greater escalation in the region shall prove supportive.
With gold currently trading at $1,970 per ounce, technical analysts expect that a break above $1,987 per ounce, which provided resistance in 2022 could act as a new support level and pave the way to the $2,000 – mark.
Other traditional safe havens that are expected to perform well include the Japanese Yen and the Swiss Franc.
Economic outlook
Since the global pandemic, runaway inflation has become the key problem that central bankers have been trying to tackle, and to their credit, they have achieved some success.
However, in most cases, the target levels have not been met yet, such as in the USA.
The outbreak of the Israel-Palestine war and the possibility of the entry of Iran could reverse much of this progress by driving a 65% increase in oil prices.
As per the IMF, a 10% increase in oil prices can reduce global growth by 0.15% while raising inflation by 0.4% in the following year.
To manage this, central bankers would be forced to tighten policy even further, or at the least, keep rates higher for longer; while trying to not stifle economic activity.
This dynamic will likely lead to capital inflows into the greenback, strengthening the dollar and leading to currency depreciation in emerging markets.
At the same time, higher inflation would threaten economic growth and consumer appetite, leading to a cycle of easy money policies and supportive frameworks.
If a recession were to occur in the United States in the coming months, the attractiveness of the greenback could be considerably dented.
Financial market participants are hoping against hope that Hezbollah’s perceived unwillingness to engage head-on with Israel may help contain the geopolitical fallout.
However, Iran’s increasingly isolated position in the Middle Eastern landscape may equally drive it to greater aggression.
Market watchers will benefit from being hyper-vigilant at this time, maintaining a nimble and diversified portfolio, and adequately analysing long-term dynamics given the potential for reactionary moves.
FINAL WORDS
● Given the uncertainty around the conflict, investors should proceed with caution.
● Of all the players who could be drawn into the war, Iran is the most crucial, and may insight significant turmoil in global markets.
● If US sanctions on Tehran were to take effect, this would choke global oil supplies, resulting in elevated inflation around the world.
● Among equities, select sectors such as defense and energy are likely to see momentum amid persistent and widespread violence.
● In terms of commodities, crude oil, natural gas, and gold may continue to see uptrends as the conflict deepens.
● To manage inflation, central banks will likely tighten policy, while the dollar should strengthen in such an environment.
● However, continuing inflation could also spur supportive easy money policies in a bid to kickstart consumption.
● Although a de-escalation of tensions would be most beneficial to the overall global economy, participants must remain vigilant, be willing to shift positioning swiftly if required and take stock of geopolitical risks in their decision-making.
