Market reaction is calm, as tensions flare in the Middle East

When Iran launched drone and military attacks on Israel on Saturday night, it was the culmination of a build up of tensions over a number of weeks. Iran had threatened to retaliate in recent days, Israel on Friday said that it would strike back if it did. Stocks tanked, the S&P 500 fell 1.46% on Friday, the Brent crude oil price rose by 3.4% in April, while gold climbed to a record high above $2,400 per ounce on Friday, before falling back sharply. The market was deeply concerned about the scale of this attack and whether it would lead to a wider escalation of war in the Middle East. At the start of a new week, that uncertainty has disappeared, there was minimal damage from the strikes and there were no fatalities. This is why US stock market futures are predicting a higher open for US stocks and why the oil price did not rise on Monday.

Israeli response could determine market reaction

There is a sense that this attack from Iran could have been a lot worse, instead Iran has drawn a line under it and said that it deems the matter concluded. From a geopolitical perspective, the focus now is on the Israeli response, however, the limited impact of the Iranian attack and the G7 calling for restraint, may limit the impact on financial markets in the short term. The question for investors now is whether a line has been crossed in the Middle East that could lead to 1, an escalation in tensions between Iran and Israel and 2, could it lead to a wider conflict that threatens the supply of oil out of the Middle East by disrupting the flow of oil through the Strait of Hormuz?

The threat of direct conflict between Iran and Israel contained for now

The initial reaction seems to be one of relief. The dollar opened the week fairly muted and US bond yields are slightly higher, suggesting that there was no flight to safe havens.  The market is well placed to absorb the events of Saturday night, but only if Israel does not retaliate, which leaves the door open to another direct attack from Iran. The more frequent drone and missile strikes occur, the more it will look like a direct conflict between Iran and Israel. The hope this week is for de-escalation, although there is a risk that Iranian allies could also target Israel in the coming days. For now, the situation is fluid, and the market is likely to react to any new event or piece of news in the coming days.

Middle East tension and the Oil price

The focus on Monday is the oil price, which fell at the start of the week. The Brent crude price is down approx. $0.5 per barrel and is currently below $90 per barrel on Monday. The Brent crude oil price has already rallied by 17% so far this year, so this decline could be a sign that the market believes enough bad news is already in the price. The biggest upward risk to the oil price right now is sanctions on Iranian oil exports from the US. These were recently lifted, but if they are put back in place, then we could see a higher long term oil price. However, this is a hypothetical threat at this stage.

Why the Oil price is muted

From a physical perspective nothing has changed for the oil price, and oil is still being pumped in the Middle East and is able to leave the region unhindered. Added to this, if the oil price was to surge, for example if this is not a one-off attack on Israel by Iran, then Opec + has plenty of spare capacity to boost production in an effort to bring down the oil price. The recent production cuts from Opec are equivalent to 5% of the world’s oil demand, so it could reverse this situation if it chose to. If the oil price continues to rise towards $100 per barrel, this could worry Opec +, as it could cause demand destruction. The global manufacturing PMI has turned a corner and is picking up in Germany and the UK. This could reverse if the oil price rises significantly above $90 per barrel. Thus, Opec has to reach a balancing act. Added to this, the US Strategic Petroleum Reserve still contains more than 360mn barrels and could be deployed to reduce the upward pressure on oil.

Overall, we think that oil could remain range bound unless there is a serious escalation in the Iran/ Israel attacks. Instead, watch the options market to see if a higher risk premium is being priced into out of the money call options. We could see some action above $100 per barrel, just in case Israel doesn’t act with the restraint its allies are asking it to do.

What the future holds for markets

Overall, we think that the impact on the economic fundamentals: global GDP, global inflation and central bank policy is negligible for now. The current situation of a semi-direct conflict between Israel and Iran with limited attacks, no wider unrest in the Middle East and no ground offensives, should be absorbed by the markets. After all, the Vix, Wall Street’s fear gauge, is already at a 5-month high, gold, a safe haven and inflation hedge, is already close to a record high. A direct war between Israel and Iran is unwanted by the world’s major powers, not least because if it did happen then it could tip the global economy into recession.  

What to watch in the coming week

The remaining unpredictability that the market has to digest is how Israel will respond, which we should get clarity on in the coming days. But, ever the optimist, the impact of the attacks on Israel was limited, which reduces the pressure on Israel to respond. Markets were already positioned for bad news, after some recent bouts of risk aversion. Thus, while we don’t expect a recovery rally any time soon, we may see fairly limited price action in the short term, until we wait for this week’s key economic data and earnings releases, along with updates from Israel about their response.