Impact of Middle East tensions on markets likely limited

What happened?

On Wednesday Iran's military executed its announced retaliation, firing missiles on a jointly run US/Iraq base in Iraq. This news, which follows the US drone strike last week in Iraq that killed Iran military leader Qasem Soleimani, was confirmed by the US government. Safe-haven proxies, such as the JPY and CHF, rallied but not decisively – both rose no more than a half percent, while the yield on 10-year US Treasuries fell to nearly 1.70% but subsequently recovered. WTI and gold rose 5% and 2.3%, respectively, before settling lower, and stock markets in Asia opened modestly lower.

What comes next?

As Iran had already announced a response would be forthcoming, the missile strike does not come entirely as a surprise to markets. There have been no reports of casualties, which may, if confirmed, lessen the US's next retaliatory step. We believe some level of retaliation by the US is likely, as President Trump already threatened to hit 52 sites in Iran if it retaliates for the attack on Soleimani. The fact that Iran claimed responsibility for the strikes also raises the likelihood of a military response by the White House. The chain of retaliation might continue depending on how the US responds, though Iran may view its actions as a proportionate response to the US strike and refrain from further action.

Nonetheless, as it's in neither side's interest to escalate to a higher level, our base case continues to assume no broader military conflict. We think it’s noteworthy that Iran’s response was to target a US military base, and not target sites that would have directly impacted the supply of oil.

What does this mean for investors?

In our base case of no major military escalation, the effects on economies and earnings on a global scale should be minor. Hence, we maintain our overweight position on equities, with a preference for US and emerging market stocks. Outside a severe disruption scenario, we do not believe that oil prices can sustain at current levels. Spare capacity in oil remains adequate (OPEC's and Russia's spare capacity is around 3.3mbpd). And we still expect an oversupplied oil market in 2020 (0.3mbpd), particularly in 1H20, due to non-OPEC supply growth (by the US and Norway) outpacing modest oil demand growth. While oil prices are likely to build in a larger risk premium amid heightened US-Iranian tensions and potential retaliatory measures by Iran, we think Brent prices will struggle to hold levels above USD 70/ bbl in 1H20. This proved to be the case last September when a Saudi refinery facility was attacked.

Diversification of assets globally remains a central tenet.

Diversification of assets globally remains a central tenet. Investors worried about deploying capital can also take advantage of relatively low volatility in the option market at present to make use of strategies that reduce portfolio volatility or add explicit protection. In addition, investors can consider adding exposure to safe-haven assets that we like from a fundamental point of view, including the JPY and gold. Regarding the yellow metal, muted US economic growth and lower real interest rates reduce the opportunity cost of holding gold. And, since gold is priced in US dollars, a weaker dollar, which we expect in 2020, supports gold prices.

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