Business Essentials for Professionals


Growing Hostilities In The Middle East Are A New Shock To Global Markets

Growing Hostilities In The Middle East Are A New Shock To Global Markets
World markets have been shaken by reports of an Israeli strike on Iranian territory that may spark a wider confrontation in the Middle East and quickly alter the course of everything from bonds to oil prices and inflation concerns.
Friday saw a decline in stocks, a temporary increase in oil prices above $3 per barrel, and a rise in safe-haven government bonds.
Although there were not many changes, the increased hostilities create more uncertainty and feed worries that rising oil costs and possible supply interruptions will keep inflation high.
"Even though these look to be more benign, telegraphed moves between Iran and Israel, and it is not the base case that we get a wider conflict, you probably do need to price in more of a risk premia," said Tim Graf, head of macro strategy for Europe at State Street Global Markets.
Here are some important lessons for markets.
On Tuesday, the International Monetary Fund outlined a "adverse scenario" in which an escalation in hostilities in the Middle East results in a 15% increase in oil prices and higher shipping costs, raising global inflation by roughly 0.7 percentage points.
Oil producing group OPEC and other major oil producers' output curbs have been the main drivers of the tightening oil supply and rising prices.
Morgan Stanley increased its prediction for Brent crude oil to $94 for the third quarter.
The S&P 500 fell about nine tenths of a percent, the Nasdaq fell more than two percent, and the Dow gained more than half a percent.
"A geopolitical risk premium appears to have been built in to the oil price, but, clearly, further escalation presents further upside risks," said Thomas McGarrity, head of equities at RBC Wealth Management.
Aware of the recent spike in US inflation, investors are keeping a close eye on oil prices. Two years ago, there was a spike in energy prices, which contributed to increased rates of inflation.
Elevated oil costs pose a risk to the inflationary trend and may lead to a reevaluation of expectations on worldwide rate reductions.
Tuesday saw the highest level of long-term euro zone inflation expectations since December at 2.39%, a key market indicator that often tracks oil. It is still higher than the 2% inflation objective set by the European Central Bank.
Oil has the potential to hinder economic growth and increase inflation, hence the ECB has stated that it is "very attentive" to its effects.
The rise in oil prices benefits energy stocks.
Earlier in April, the European oil and gas equities and the S&P 500 oil index reached all-time highs before retreating.
This year, U.S. oil stocks have increased by about 12%, outpacing the 5% gain in the S&P 500 as a whole.
Yardeni Research sees a potential increase in Brent crude to $100 in the upcoming weeks and advises taking a "overweight" position in energy stocks.
Following Russia's invasion of Ukraine in 2022, oil momentarily reached its highest level since 2008. It was at $139.
"The rise in oil prices complicates central banks' efforts to bring inflation back down to target levels," said RBC's McGarrity. "Having exposure to the energy sector arguably provides the best hedge to both inflation and geopolitical risks in equity portfolios near term."
The desire to sell bonds given the renewed dangers of inflation from rising oil prices for the time being is trumped by the demand for safe havens like U.S. or German bonds, especially before the weekend.
U.S. 10-year Treasury rates dropped from recent five-month highs by as much as 15 basis points on Friday. They were last down 6.5 bps at 4.58%.
According to Philip Shaw, chief economist at Investec, "that suggests markets are more concerned about the need for safe havens than the immediate inflationary implications of higher energy prices."
Demand for safe haven assets has also helped the dollar and Swiss franc, with geopolitics and rising oil prices contributing to a dollar surge driven by a reduction in expectations on U.S. rate cuts.
With the yen near 34-year lows, the strength of the dollar puts further strain on economies like Japan, and traders are wary of potential central bank intervention.
A further escalation in the Middle East, according to ING currency analyst Francesco Pesole, might result in losses for the currencies of New Zealand, Australia, Sweden, and Norway as risk sentiment declines; conversely, the Swiss franc could strengthen.
Growing economies that are net importers of oil, like Turkey and India, are also harmed by rising oil costs and a strong currency.
This week saw historic lows for the Indian rupee.
Because of caps on petrol pump prices and a lack of domestic oil refining, weaker local currencies and rising fuel prices have hurt government revenues even for Africa's largest oil exporters, Nigeria and Angola.
"A return to $100+ in oil prices may convince the Fed to throw in the towel on hopes of monetary easing for now, and a potentially magnified impact across EM currencies of geopolitical risk would fuel a substantial rotation back to the dollar," said Pesole.

Christopher J. Mitchell

Markets | Companies | M&A | Innovation | People | Management | Lifestyle | World | Misc