What are the macroeconomic impacts and likely responses of global markets in the event of a full-scale conflict in the Middle East?
(Picture: Juli Kosolapova, Unsplash)
Background
The conflict between Israel and Hezbollah intensified after the assassination of Hezbollah commander Fuad Shukr on July 31, 2023. On the same day, Hamas’s political chief Ismail Haniyeh was also killed in Tehran, leading Iran's Supreme Leader Ayatollah Ali Khamenei to vow "harsh punishment" against Israel.
This has raised concerns that Iran or other Iranian-aligned groups in Yemen and Iraq might join Hezbollah in a broader conflict against Israel.
Recently, Israel launched a pre-emptive strike on Hezbollah positions in Lebanon, accusing the group of planning an attack. Hezbollah responded by firing over 200 rockets and drones at northern Israel. Both sides claimed success but signalled no interest in escalating to a full-scale war.
Historically, Hezbollah and Israel have avoided large-scale conflicts since their last major war in 2006, maintaining a tense but controlled situation.
What are the Chances of a Big War?
Factors suggesting a full-scale war:
Ongoing volatility: Despite the current exchange of attacks between Israel and Hezbollah, and signals that both sides may be temporarily satisfied, the situation remains highly volatile. Any small provocation could easily reignite hostilities on a larger scale.
Iran's unanswered vow of revenge: Iran's promise of revenge for Ismail Haniyeh's assassination remains unfulfilled. Iran's constitution also enshrines a stance against Israel, which could motivate further aggression.
Security concerns in northern Israel: Israel’s priority to ensure the safe return of displaced citizens to northern Israel may necessitate aggressive military actions, potentially escalating into a full-scale war.
Political calculations: Prime Minister Netanyahu may push for aggressive military strategies to strengthen his political position amidst domestic and international pressures.
Factors suggesting against a full-scale war:
Hezbollah's reluctance: Hezbollah is not currently interested in a large-scale war, particularly given Lebanon's severe economic crisis. The group prefers a secondary role in the Israel-Hamas conflict, avoiding becoming the main combatant.
Israel's focus on Gaza: Israel is primarily focused on its ongoing war in Gaza and is reluctant to open a second front. A new conflict with Hezbollah would likely lead to heavy casualties and significant financial costs, which Israel is keen to avoid.
Iran's calculated restraint: Iran has shown restraint, not yet retaliating for Haniyeh’s assassination. There have been hints that a potential deal between Israel and Hamas could avert further escalation.
International diplomatic efforts: The U.S. and its allies are actively pursuing a diplomatic resolution, with negotiations on a ceasefire and the release of hostages offering a path to de-escalation. The presence of the U.S. Navy's carrier strike group in the Mediterranean also serves as a deterrent against Iranian escalation.
Conclusion: We estimate that further exchanges of strikes between Israel and Hezbollah are likely, with a similar response from Iran as seen in the rocket launch back in April (causing no severe damage to Israel). However, a large-scale war remains unlikely in the short term, though possible as the situation is highly volatile and could change rapidly.
Macroeconomic and Stock Performance Implications if a War Begins
Equities: A full-blown war could lead to a broad sell-off in global stock markets, especially in sectors sensitive to oil prices, such as transportation, aviation, and chemicals. Defensive sectors like utilities, healthcare, and gold-related equities may attract investor interest. Reducing exposure to high-risk equities, particularly in emerging markets, and focusing on resilient sectors and companies with strong fundamentals would be advisable.
Bonds: Geopolitical tensions could lead to heightened volatility in bond markets. Investors might seek safe havens, driving down Treasury yields, but if oil prices cause inflation to rise, the Federal Reserve may need to keep interest rates high, pressuring bond prices downward. High-quality bonds with shorter durations could mitigate these risks.
Oil and energy: The energy sector is likely to be directly affected by any conflict escalation. Oil prices could surge due to potential disruptions in Middle Eastern supply, benefiting energy companies with significant oil production. However, higher oil prices could hurt other sectors, making energy stocks a key hedge against broader market declines.
Gold and precious metals: Gold is expected to perform well as a safe-haven asset during geopolitical instability, potentially reaching new highs if the conflict intensifies. However, investors should be cautious of volatility in gold prices, balancing their portfolios to avoid overexposure while maintaining a hedge against inflation and market turmoil.
Conclusion: If the threat of war increases, investors should brace for heightened volatility across all asset classes. Key strategies include reducing exposure to high-risk equities, particularly in emerging markets, and increasing allocations to safer assets like high-quality bonds, defensive stocks and gold. Maintaining focus on long-term investment goals and avoiding panic selling during periods of uncertainty is crucial.
How Do Stocks Perform Following Major Geopolitical Events?
We analyzed selected geopolitical events, particularly those involving wars or terrorist attacks, since the S&P 500's inception in 1957, to explore the impact on the index’s returns one day, one month and one year after each event. The results are summarized below.
The S&P 500 typically experiences an immediate negative reaction to geopolitical crises, with an average loss of 0.8% on the day following the event. This reaction is common in the aftermath of significant geopolitical shocks, reflecting increased uncertainty and fear.
One month after the event, the S&P 500 historically shows signs of recovery, with an average gain of 1.7%, indicating that initial shocks are often followed by stabilization and even gains as the situation becomes clearer.
Over the course of a year, the S&P 500 is generally flat on average, with a 0.2% decline. The one-year performance varies widely, with some events leading to substantial gains and others to significant losses, suggesting that the long-term market impact is highly dependent on the resolution and broader economic implications of the event.
Conclusion: Given the historical data, investors should be cautious but not overly reactive in the immediate aftermath of a geopolitical crisis. The initial market drop might present buying opportunities if the long-term fundamentals remain strong. However, it is essential to monitor the situation closely, as the long-term effects can vary widely depending on the nature and resolution of the event.
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