The tragic incidents in Israel and Gaza have cast light on a key geopolitical risk. There are two possible scenarios: a. A swift conflict that is contained within Israel/Gaza, like the 2014 war, without other parties joining; b. a conflict that draws in major players, notably Iran, disrupting oil supplies. Markets are likely under-pricing the risk of a near-term escalation, although such conflicts have rarely had a lasting impact on global markets.
Sanguine markets: Global financial markets have seen limited impact from the latest developments, with no major technical levels broken this week. The closest we got were WTI crude oil prices testing the 50DMA resistance around USD 85/bbl on its rebound before pulling back and USD/CHF testing the 200DMA support on the back of some safe-haven demand for the CHF. WTI crude oil is now trading more than 10% below its 10-month high hit in September. If anything, key risk assets, such as the S&P500 index, rebounded from a major technical support (200DMA, which coincides with the uptrend line from last year) as government bond yields pulled back.
The market reaction suggests investors do not expect an escalation in the conflict ensnaring the broader region and disrupting oil supplies. The reasoning behind this relatively benign outcome: major stakeholders in the Middle East (except for Israel) do not have an incentive to see a broader conflict engulfing the region. They would rather prefer to confine and resolve the conflict among the involved parties. Such a scenario would keep Middle East oil supplies flowing. History suggests that Middle East conflicts that did not disrupt oil supplies had no lasting impact on oil prices (see chart above) or global financial markets over the medium term.
Risk-off scenario: However, the risk of the alternative scenario is non-negligible in the next few weeks, given the internal political compulsions of Israel’s establishment to act strongly. The key is whether Iran or its allies join the conflict.
If they do, it could lead to disruption of oil supplies, reigniting inflation concerns, hastening an economic downturn and a sell-off in risk assets. US and European military and diplomatic efforts are aimed at preventing such an escalation in the conflict.
Bonds as a hedge: The latest geopolitical development increases our conviction on Developed Market government bonds. As the pullback in bond yields this week showed, high-quality bonds offer amongst the most attractive hedges against any escalation in the geopolitical conflict. Although tight job markets (US job creation in September was much stronger than expected), still-elevated core inflation and the risk of higher oil prices could deter the Fed and other major central banks from cutting rates any time soon, bond yields close to their 16-year highs offer investors attractive returns over a 12-month or longer horizon. There is also scope for significant capital gains if the geopolitical uncertainty adds to tight monetary conditions to hasten a global economic recession.
Energy and defence equities, gold: Gold has historically gained in a riskier geopolitical environment. Last week, we flagged gold had fallen to attractive levels around USD1,828/oz. We see further upsides on sustained safe-haven demand, with 1,940 as the short-term resistance. Energy sector equities have close correlation with oil prices and should act as a hedge against any escalation in the conflict. The US defence sub-sector is another likely beneficiary in such a scenario.
USD bounce. The USD index (DXY) bounced on Thursday, reversing losses over the past couple of weeks. Market reversal indicators (fractals) in DXY and GBP/USD fell this week below a key threshold level (1.25), while the same for EUR/USD came close to the threshold, raising the risk of a reversal of recent trends in these currencies. Any escalation in the Israel-Gaza conflict in the coming weeks could offer the USD some support. Nevertheless, the CHF and JPY are likely to outperform other currencies in such a scenario, given their safe-haven characteristics and the JPY’s significant undervaluation.
