Middle East conflict in context

The Iranian attack on Israel on Saturday 13 April followed as a retaliation measure against the Israel bombing raid of Iranian consulate in Damascus, Syria, on 1 April. After this attack, however, Israel retaliated against Iran last Friday, according to US media.

Despite this huge increase in geopolitical risks, investors did not overreact. Most asset classes that are sensitive to this risk, remained broadly unchanged. Indeed, on 3 April, euro-dollar was trading at 1.077 versus 1.066 on Friday close. Brent was trading at USD 89 versus USD 87 at the end of last week. 10 year US Treasury was around 4.35% versus 4.65% this morning. Only gold, close to 2400 USD/ounce, seemed to have benefited from those developments.

Geopolitical risk in the Middle East is key for investors, as it can have a significant impact on oil prices and, consequently, on the world economy. Most observers consider three main scenarios regarding the relation between Israel and Iran.

The first one is a confined conflict between the two countries, without any further direct confrontation. In that case, impact on oil prices and the economy should be muted.

The second scenario is a confrontation through proxies, with the warfare taking place in for example Lebanon or Syria, but not directly between the two countries themselves. In that case, the impact could be limited to both oil prices – through a small geopolitical premium – and to economic growth worldwide.

The last scenario is a full war between Iran and Israel, that could have broader implications for the Middle East. This could trigger a significant oil-price shock, feeding into higher inflation and a significant risk of a recession for the world economy.

Since Friday, most observers have noted that the risk of a war between Israel and Iran is decreasing: retaliation from Israel seems to have been limited, the US did not participate, Israel did not confirm its operation and Iran has labelled the development as being immaterial. Therefore, it is considered that Israel and Iran are not looking for more escalation, for the time being.

Since early 2016, political and geopolitics risks have been increasing with Brexit, the trade war between the US and China, war between Russia and Ukraine, the Hamas attack on Israel and the developments of the last two weeks. Despite this challenging environment, equities behaved particularly well. Since 2016, the MSCI World has increased by 123% - more than 10% on an annualised basis.

Those numbers remind us of a clear lesson learned from history: geopolitical risks typically do not have a long lasting impact on financial markets, as long as they do not trigger a world recession. Since 1945, close to 30 geopolitical events can be counted. On average, the maximum market correction triggered by geopolitical events is around 5% with a recovery period of a few days or months.

In the meantime, a new narrative is developing on financial markets: higher rates for longer. After a strong disinflation phase that led to an ideal environment for equities and bonds, stronger US inflation numbers since the beginning of the year have been challenging this state. Therefore, investors are considering now less than two rate cuts from the US Federal Reserve, the Fed, in 2024, from an expectation of nearly six at the end of last year. 10 year US Treasuries increased by 80 basis points to 4.65%. Fed Chair Jerome Powell indicated last week “that it's likely to take longer than expected to achieve that confidence" of inflation coming back to 2%.

As a consequence, equity markets are consolidating, in particular growth stocks of which the valuation feels the pressure of higher interest rates. We recognise that the “last kilometre of disinflation” is harder than expected. Still, we expect that inflation will continue to slow down in the coming months, allowing the Fed to cut rates three times in 2024.

As always, investors should not overreact to geopolitical risks. While geopolitical events are often unpredictable, the worst-case scenario concerning Israel and Iran appears to be becoming less likely since Friday. Regarding the Fed monetary policy, disinflation should resume in the US in the coming months, which would give the Fed the confidence to cut rates.

As such, we remain moderately overweight on equities and bonds. We continue to expect a soft landing outcome for the world economy, supported by central bank easing, which should be favourable for both asset classes.

Olivier Raingeard - Global Head of Equity Strategy