Market comment: Iran-Israel conflict fuels investor uncertainty

The tensions between Israel and Iran have escalated significantly since Friday, with multiple attacks between the two countries. So far, investors’ reactions have been quite muted: equity markets experienced a minor step back, safe- haven assets (dollar and gold) progressed modestly while US long-term interest rates increased by a few basis points. The main asset class impacted by this conflict is oil with prices increasing significantly on Friday. Crude oil is back to its level registered at the beginning of the year, around USD 73 per barrel for West Texas Intermediate (WTI) oil.

Investors are primarily concerned about the oil market because any significant disturbance could impact more broadly the world economic outlook. There are two feeders of any disturbance: first, Iran’s oil production – around 3.4 million barrels per day – that represents about 3% of the world production. Secondly, the Strait of Hormuz, a crucial chokepoint through which about 20% of the world’s oil production is shipped.

So far, the impact on energy infrastructure has been minimal. Two gas factories and two fuel depots have been hit and a fire within a gas processing unit has led to a partial shutdown of the South Pars natural gas field. But Iranian oil fields and export terminals have not been targeted and remain intact. If Iranian oil infrastructure remains intact, any de-escalation could lead oil prices back to the levels registered before the strikes.

A more disruptive scenario would be an attempt by Iran to close the Strait of Hormuz. Such a development would lead to much bigger tensions in oil prices, which could potentially go above USD 100 per barrel. However, the odds of such a scenario seem to be low as geopolitical analysts consider the Iranian possibility to do so unclear and anticipate a quick reaction from the US to avoid such a development.

Since World War II, investors have experienced several conflicts in different regions, from those in the Middle East to the Russia-Ukraine war in Europe. History helps us to draw three conclusions from the impact of conflicts on financial markets and economy. First, on average, conflicts tend to generate limited volatility on financial markets. Secondly, in most cases, the correction of asset prices is recovered three months after the beginning of the conflict. Third, economic consequences of conflicts are also limited unless a significant and prolonged impact on commodities is experienced.

Based on lessons from history, investors should not overreact to market volatility triggered by geopolitical risks. Our strategy remains unchanged. In May, we decreased equities to neutral during the strong rebound of risky assets. This decision was made considering that uncertainties related to Trump’s policies would likely trigger further volatility in the coming months. Within equities, we are neutral across regions. We remain slightly overweight on bonds, through high quality bonds which should offer diversification benefits in case of an adverse scenario for the world economy. Finally, we have also taken a position in gold for diversification purposes given this uncertain environment. We are closely monitoring the situation and will adjust our strategy if necessary.

Olivier Raingeard
Global Head Equities