What do developments in Saudi Arabia mean for markets?

Geopolitical tensions have risen in the Middle East. Last week Saudi Arabia launched a probe into alleged corruption in the Kingdom. The ongoing conflict between Saudi Arabia and Yemen escalated with the interception of a missile allegedly launched by Iranian-backed Yemeni Houthi rebels towards Riyadh. And the risks of a proxy war between Saudi Arabia and Iran in Lebanon increased. Lebanese Prime Minister Saad Hariri resigned, citing Iran’s role in his country and the Saudi Minister of Foreign Affairs called on Saudi citizens to leave Lebanon immediately.

We continue to monitor events closely, but for now expect the market impact of these developments to remain localized, with the following broader implications for investors:

1. Home is not always the safest place to be. Increased tensions erased as much as $7 billion in value from the region’s stock markets, with the combined market capitalization of equities in the six-nation Gulf Cooperation Council falling to its lowest level in a year, according to Bloomberg data. This is a reminder that despite investors' natural tendency to buy what is familiar, home bias represents a riskier investment than a globally diversified portfolio.
2. The situation is unlikely to lead to sustainably higher oil prices. The anti-corruption drive is likely to consolidate the power of Crown Prince Mohammed bin Salman, who favors extending the latest OPEC+ deal to limit global oil supply. However, we believe a deal extension is already priced into crude. Saudi energy minister Khalid al-Falih remains in place and there have been no indications of reductions in tanker shipments from Saudi Arabia.
3. Localized volatility need not disturb the global calm. Global markets continue to take a sanguine view of specific geopolitical risks. The VIX index of S&P 500 option volatility, the market’s fear gauge, declined to a record low weekly close of 9.14 on 3 November. Amid increased Middle East tension last week the VIX rose only modestly to 11.29, and other factors, including a correction in global equities, were partly to blame.

Our base case is that the reform process continues in Saudi Arabia and that regional geopolitical tensions remain confined to exchanges of harsh rhetoric, allowing local financial markets and energy prices to stabilize.

But recent developments have increased the potential for further political upheaval in Saudi Arabia and/or a proxy war in Lebanon. This increases the risk of disruption to Saudi oil output and substantially higher oil prices that could harm risk assets. Saudi Arabia is the global oil swing producer, controlling most of the market’s 2.5-3m barrels/day spare capacity; a meaningful supply disruption could send prices significantly higher. However, our analysis of supply-driven oil price spikes since 2000, which did not involve direct disruption of Saudi supply, shows a limited impact on equity markets. The maximum drawdown for global equities averaged 6% during these periods. Furthermore, equity losses were recovered even before oil prices peaked, which on average was three months later.

Bottom line

The focus of geopolitical tension has shifted on to the Middle East following Saudi Arabia’s anti-corruption crackdown and an escalation in the friction between the Kingdom and Iran. But while risks have increased, we expect the market impact to remain localized, which investors can mitigate through global diversification. We don’t expect the current situation to prompt a sustainable rise in the oil price or to destabilize global equity markets.

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