Middle East tensions: Assessing the impact

In a historically unprecedented move, Iran launched a direct military assault on Israel on 13 April. This action was taken in response to allegations from Tehran that Israel was responsible for an air strike on the Iranian consulate in Syria on 1 April. As a response, Israel launched a retaliatory strike early on Friday morning. The risks of a potential escalation into a wider conflict in the region is causing concern across the globe, as evidenced by increased market volatility and nervousness among investors.

We summarise our key views and implications across the different asset classes:

Oil

Both the hoped-for de-escalation of tensions and the likely continuation of armed conflict are bound  to have little impact on the Gulf region’s ability to produce and transport oil. We therefore do not see recent events as having an impact on our global growth and inflation outlook.

For oil, the situation seems similar to that of last autumn, when prices temporarily rose above  USD 90 per barrel. There are several reasons for an eventual reversal, including a slowdown in demand and an easing of Saudi Arabia’s production cuts. 

Gold

For gold, we do not see the tensions as a game changer either. In line with the historical pattern, there should be no lasting impact on prices, barring an escalation of the situation.

Currencies

In currencies, a continuation of the conflict at the current level of escalation supports our base case of extended short-term USD strength based on a late cutting US Fed. Further escalation would spur risk aversion and cause additional strengthening of the safe-haven USD.

Equities

In equities, history tells us that equity markets tend to recover swiftly from geopolitical events unless they lead to persistently higher commodity prices. We continue to regard the oil & gas sector as a good diversifier in an equities portfolio in times of heightened geopolitical risk.

Due to the sheer shock and awe that geopolitical crises bring, which monopolise everyone’s attention, the most relevant information for financial markets this week was mostly lost in translation over the past few days, that the ‘higher for longer’ rates narrative is backed by surprisingly strong fundamental data out of the US.

US growth: Stronger for longer

US economic growth is likely to have remained strong in the first quarter, extending a string of strong quarterly growth rates over the past one-and-a-half years. Private consumption expenditure was again an important growth driver. Solid growth, with unemployment at 3.8%, and inflation at 2.7%, suggests that there is no urgency to ease monetary policy.

Various forecasts for US GDP growth suggest that the economy grew much stronger than our conservative estimate of a quarterly annualised growth of 1.5%. A solid increase in potential spending in the first three months of the year suggests that private consumption was again an important growth driver. Growth is also likely to have been supported by government consumption and investment, despite the restrictive monetary policy stance. Traditionally volatile contributions to growth, such as net exports and private inventories, are expected to have made small negative contributions to growth.

A solid first-quarter growth figure will vindicate the Fed’s recent shift away from imminent interest rate cuts. There is no urgency to ease monetary policy when the economy is growing at or slightly above potential; unemployment is at 3.8% and inflation is at 2.7%.

We expect the recently priced-in ‘higher for longer’ rate outlook to be vindicated by a solid GDP print. We also expect the Fed to start cutting rates only in September this year, a view that is now backed up by money market pricing, and there is a chance of further rate cuts at the November and December Federal Open Market Committee meetings, despite the overlap with the US presidential elections. Our confidence in these two rate cuts is rather low. 

What does this mean for investors?

They say politics is a cynical business. In that case, so is geopolitical analysis. For those who have followed as many crises as we have over the years, the playbook is most often quite straightforward. There is something brewing, then it blows up and markets panic, and when the headlines are all over the place, the fear premium starts fading for good.

The Middle Eastern crisis seems to be sticking to the playbook: after spiking fears, the situation seems quite unlikely to put a lasting oil-price tax on the global economy. That said, rates may stay higher for longer for other reasons, and a key driver is US growth. This may prove to be a good time to buy some turnaround stories in single equities.