January 07, 2020
Just as trade war fears were receding with the US and China set to ink a Phase 1 trade deal on January 15th, a new risk has flared up, throwing cold water on the market’s risk-on rally: rising tensions in the Middle East.
On January 3rd, a targeted US airstrike in Iraq killed Major General Qassim Soleimani, the orchestrator of Iran’s external military operations for more than 20 years. Soleimani was the head of the Iranian Revolutionary Guard’s overseas forces and was the man on the ground controlling the regime’s far-flung influence across the region. According to the US administration, it was a preventative measure as it was believed he was “was plotting to kill many” Americans. Trump declared that “We took action last night to stop a war. We did not take action to start a war.”
However, with one of the country’s most prominent figures having been killed, retaliation from Iran in some shape or form, is pretty much inevitable: it is just the how and the when that remain as big question marks. Iran’s Supreme leader Ayatollah Ali Khamienei threatened “severe retaliation” and Trump subsequently identified 52 Iranian targets, including cultural sites, that the US would hit if Tehran does retaliate. Already, the Iranian government said it no longer considers itself bound by the limits on the enrichment of uranium set out in the 2015 nuclear accord it signed with other super powers. Earlier in the year, Trump was accused of “diplomatic vandalism” for pulling the US out of the nuclear deal. Soleimani’s successor, Brigadier General Esmail Ghaani, has vowed to expel the US from the Middle East.
Due to the interlacing complexities in the region, it is almost impossible that events remain contained within Iran. Already, following the attack on its soil, the Iraqi government voted to expel US troops who have been present in the country for almost 17 years since Saddam Hussein’s regime was toppled in 2003. Trump said that US troops won’t leave without billions in payment for air bases which they built there and that Iraq will face sanctions if they do leave.
Markets exhibited a textbook Pavlovian reaction to the news:
- Oil prices shot up – Brent crude went above $70/barrel to its highest level since September when drone strikes (which the US blamed on Iran) temporarily knocked out half of Saudi Arabia’s oil production.
- Equities (which were already ripe for profit-taking) declined.
- Investors made a beeline for safe haven bonds and currencies.
- Gold prices closed in on $1600/ounce for the first time since 2013.
Until Iran’s reaction is known, investors will continue to huddle in defensive corners of the market and we would steer clear of risky assets.
To try and divine Iran’s next move would be speculating and so we await concrete news. What we do believe is that Iran will avoid any grandiose attack that would justify US air strikes on Tehran. Any counter-attack is likely to come in the form of small strategic hits. The US state department warned on Sunday there was a heightened risk of attacks on oil facilities and other targets in Saudi Arabia.
In markets, oil will remain centre stage, with its price highly tethered to the news flow.
Analysts estimate that prices on Brent Crude could reach $150/barrel creating a boost to inflation if Iran closed the Strait of Hormuz, through which roughly 20% of global oil supply is transported. But this is not our base case. If the Strait remains open, oil prices should remain somewhat capped by the fact that global energy production has undergone decentralisation – now, there is idle capacity in other regions. In the US, domestic production runs at almost 13M barrels/day, with consumption at 21M barrels/day. In the past, higher oil prices would come as a direct blow to American consumers, and threaten economic growth but more recently, oil sector capex has proven sensitive to prices, and US shale producers will likely ramp up production in response to increases.
If Iran’s response is more hawkish, long-duration bond yields could potentially fall to at least mid-2019 levels. Havens would receive a leg-up while riskier assets such as equities and emerging market currencies would take a hit. We do not know how this story will play out and as of now, we consider this more of a headline story than an economic game changer. Geopolitical concerns have caused a huge bid-up in oil and gold and we would caution against blind momentum buying of these commodities. Without knowing Iran’s next move, it is premature to asses the economic outcome, however, we do note that corporate investment is already at depressed levels and any further deceleration in the short- term, on the back of reduced confidence, could create some pot-holes in the macro picture.
Author: Group Investment Office