Market Volatility and the Conflict in the Middle East

By Steve Gelber on October 27, 2023

The Israel-Hamas war has shocked the world, and along with other factors has resulted in a pullback in the equity markets.  The Standard and Poor’s 500 Index is currently flirting with a correction (defined as a 10% pull-back, which markets are approaching from July highs for the year).  The geopolitical ramifications are important and will likely not be fully understood for years to come.  Of course, the most important impact is human, and the loss of life has been tragic. Our thoughts and prayers are with all of those who have been affected, including our clients and their families.

While it is difficult during times like these, our job as investors is to assess what impact the conflict might have on the global economy and financial markets, and then determine if we need to make adjustments in collaboration with our clients. With that said, from that lens should investors be worried?  Well, it depends.

The situation is incredibly fluid.  The geopolitical web is a complex one that stretches well beyond the two sides involved.  And to that end, COVID-19 and the Russia-Ukraine war has shown us economically speaking that we should be mindful of the intricate interdependencies that shape the global economic and geopolitical landscape. In this instance, the attack seems to have put a stopper on U.S.-brokered negotiations around Saudi-Israel relations, things seem to be intensifying between Israeli forces and Iran-backed Hezbollah militants at the Lebanon border, and American troops have been attacked by militants and drones in Syria, Iraq, and at sea; all while questions abound over whether Iran was involved in some way.  Further, Russia and China have entered the conversation offering their support on a two-state solution and with China showing a naval presence in the area.  Needless to say, geopolitical tensions are elevated, and geopolitics plays a pivotal role in shaping people’s perceptions of economic growth.

To gauge any investment impact, we must closely watch the potential for escalation and the follow-through effect on natural resources given it seems like the clearest link to corporate profits, inflation and consumer sentiment.

What if the situation remains contained?

Neither side are key oil players, and the conflict as it stands does not meaningfully impact oil production or supply.  So far, markets seem to think this will remain the case.  Brent crude prices rose about 10% in the weeks following the October 7^th attack, but at the time of writing, prices have retreated and are still well off this summer’s highs.

These muted moves also come as global oil supply and demand today are pretty well balanced. This is very different than conditions faced when Russia invaded Ukraine in 2022; back then, oil supply was lacking relative to demand, and as the event disrupted even more supply, prices soared resulting in major market disruptions from credit to broad equity markets.

To us, this means that today’s markets can handle a moderate disruption – for instance, if the United States were to more strictly enforce sanctions on Iranian oil (which accounts for about 4% of global supply). While tensions between the United States and Iran have cooled a bit lately and enforcement of those sanctions has been more lax, if Iranian involvement is confirmed those sanctions would likely intensify taking some of that Iranian oil offline.  

What if the situation escalates?

So much is uncertain, but a wider conflict would of course bring greater risks.  

Some see this conflict as reminiscent of the 1973 Yom Kippur War during which Arab OPEC countries implemented an oil embargo targeted at nations that had supported Israel.  As a result, the oil prices surged over 300%, catalyzed high inflation and an economic recession that led to a prolonged rout in stock markets.  As of now, there is no evidence of similar actions being taken. Further, Israel has better relations with other Arab countries compared to then, and global oil supply is not nearly as concentrated. However, the conflict could escalate, and if it formally pulls Iran into the fold, shipping routes like the Strait of Hormuz – which traffics about 20% of global oil consumption – could be disrupted and that would be much harder to digest.

Here, it’s possible other producers could step in to stem some of the bleeding. The U.S. has been rapidly adding supply, and given time, it could add quite a bit more. It wouldn’t be enough to hold prices steady, but it would help to mitigate some of the pain. Some comfort might also come from the fact that the United States is less energy intensive than it used to be: Compared to the early 1970s, it now takes over 70% less oil to generate one unit of GDP.

So how will this time play out for markets?

And so, the effect of the latest Israel-Hamas conflict on global financial markets will largely depend on the involvement of other major regional powers.  If the conflict remains between Israel and Hamas, the effect will probably be limited and arguably exclusive to countries with direct trade exposure to Israel or Palestine.  However, if the conflict spreads to major oil-producing nations in the region such as Iran, the global economy could face severe repercussions as energy costs for businesses and households could spike in the short-term if supply is interrupted.

Higher energy prices could likely hamper central banks’ efforts to tame inflation pressures in most advanced and emerging economies.  If this leads to a “higher for longer” monetary policy that keeps interest rates elevated, it would push up the cost of borrowing and refinancing by governments, companies and people.

History can offer some insights into how the impact on the global economy could unfold under these different scenarios. For instance, the 50-day war between Israel and Hamas in 2014, which killed 2,200 people, mostly civilians, had no significant effect on the global economy or financial markets.  Yet, when Israel and Hezbollah clashed in Lebanon in 2006, oil prices surged globally due to fears of a broader conflict in the Middle East.

Unfortunately, there is another factor to consider at the moment. The escalation of the Israel-Palestine conflict has happened alongside the realignment of various global alliances. This slow creep of “deglobalisation” can be seen in a shift in trade policies in recent years. 

But there has been some nuance in the international reactions to the attack. With most western countries quickly voicing support for Israel’s right to defend itself, while countries like China and Russia called for a ceasefire without taking a stance on Hamas.

This suggests that the issue of Israel-Palestine could tie in with the broader trend towards the new geopolitical divisions that were already starting to emerge before Hamas’s attack.

A prolonged conflict between Israel and Palestine, especially with the involvement of major regional powers, could further accelerate this global realignment which could disrupt trade and lend to short-term disruptions to global growth.

Needless to say, there are many factors at work in the complex web of geopolitics and the global economy.  We at Financial Principles are closely monitoring developments and will remain in contact with our clients and partners as the situation develops.  In the interim, we urge clients to remain focused not on short-term market volatility but on their financial plans. For our clients with current income needs, their portfolios have been crafted with volatility in mind.  For our clients who are still accumulating wealth, we view bouts of volatility as long-term investing opportunities and encourage clients to stick to the sound financial principles of diversification and continued dollar cost averaging with their saving and investing goals.

As always, should you have any questions or concerns, do not hesitate to contact our office.