Markets Weigh Risk of Retaliation Cycle After Iran Hits Israel

(Bloomberg) — Financial markets will face geopolitical concerns in the coming week, with much depending on whether Iran’s unprecedented weekend attack on Israel will prompt rounds of retaliation.

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With investors already rattled by persistent inflation and the prospect of longer interest rates, the escalation of the Middle East crisis will bring new volatility when trading resumes.

When Hamas attacked Israel in October, the biggest fear among many market participants was that Iran would eventually be drawn into the fighting. As the conflict spreads, many say oil could surpass $100 a barrel and expect a flight to government bonds, gold and the dollar, along with further stock market losses.

A spike in nerves may be dampened by Friday’s flight to safety in the markets in anticipation of a strike, Iran’s statement that “the matter can be considered closed” and a report that President Joe Biden told Israeli Prime Minister Benjamin Netanyahu said the US will not support an Israeli counterattack on Iran.

“The natural reaction for investors at times like this is to look for safe-haven assets,” said Patrick Armstrong, Chief Investment Officer at Plurimi Wealth LLP. “The responses will depend somewhat on Israel’s response. If Israel does not escalate from now on, it could provide an opportunity to buy risky assets at lower prices.”

Risk-addicted Wall Street funds are being shaken as the bad news piles up

Bitcoin provided early insight into market sentiment. The token fell nearly 9% in the wake of Saturday’s attacks, but recovered on Sunday to trade around $64,000.

Stock markets in Saudi Arabia and Qatar posted modest losses on thin trading volumes. The Israeli stock benchmark swung between gains and losses at least nine times before closing with a small gain.

“Middle East markets opened with relative calm after Iran’s attack, which was seen as a measured retaliation, rather than an attempt at escalation,” said Emre Akcakmak, senior consultant at East Capital in Dubai. “However, the impact on the market could extend beyond the Middle East due to secondary effects on oil and energy prices, potentially impacting the global inflation outlook.”

Investors will now weigh the risk of a strike and counterstrike cycle, with many looking to oil as a guide to how to respond. Brent crude is already up nearly 20% this year and is trading above $90 a barrel.

Although the conflict in the Middle East has not yet had any impact on production, attacks by the Iranian-backed Houthis in the Red Sea have disrupted shipping. Traders are particularly concerned that a spreading conflict could disrupt tanker shipments from the Persian Gulf through the Strait of Hormuz.

Israel’s war cabinet discusses response to Iranian attacks: TOPLive

Concerns about the unrest in the region are also permeating global markets. The S&P 500 has suffered its biggest weekly decline since October due to higher-than-expected inflation and disappointing bank profits.

In the bond market, traders will be weighing the risk that higher energy bills could add to swirling inflation fears. While government bonds tend to benefit in times of uncertainty, the threat of interest rates remaining high could limit movements. US stock and bond futures open on Sunday at 6pm New York time.

Meanwhile, gold has been falling, rising 13% this year to reach a record above $2,400 an ounce. Investors have also sought the stability of the US dollar. An index of the currency rose 1.3% last week, its best performance since late 2022.

Here’s what investors and analysts say:

Erik Meyersson, chief emerging markets strategist at SEB:

“Our oil analysts do not see many signs of a geopolitical risk premium in oil prices so far. We expect this to reflect the market’s perception that the risk of escalation is low so far. This balance will likely be tested if Iran and Israel continue to attack each other.”

Gonzalo Lardies, senior equity fund manager at Andbank:

“A new environment of uncertainty is now opening up, but the market has already partially priced this situation in on Friday, so if the situation does not worsen, the impact should not be very large. The risk is that this situation will escalate and there will be contamination in the region.”

Alfonso Benito, Chief Investment Officer at Dunas Capital:

“I wouldn’t expect sharp declines given the way Israel has defended its air shield. We should see defense companies rise, oil and gas rise, while airlines could decline. Bonds will rise, but I don’t think excessively. Investors could take advantage of this to partially correct the gains seen in recent months.”

Joachim Klement, strategist at Liberum:

“The response will depend greatly on Israel’s response today and whether the US will succeed in containing Benjamin Netanyahu.”

“In the coming days, equity markets will focus on the geopolitical situation, rather than central bank action or the strong US economy. Therefore, we expect the rally to stagnate until there is more clarity as the situation in Iran and Israel calms down. If we get into a shooting war between Israel and Iran, the meeting will be postponed longer.”

Mark Matthews, strategist at Bank Julius Baer in Singapore:

“The good thing is that Iran warned about the attack well in advance. Military analysts say this was done in a way that minimized casualties. I don’t see why this would cause Fed interest rate expectations to fall further or oil prices to rise sharply. Iran is trying to defuse this, and so is the US. The key is what Israel’s response will be, and then Iran’s response to that. If Israel carries out a de-escalating attack, and the Iranians carry out an even more de-escalating attack, then it’s over.”

Geoff Yu, senior strategist for EMEA markets at BNY Mellon in London:

“There is room for further dollar accumulation even with recent buying following the CPI data. Our clients remain overweight the euro, the Canadian dollar and some high-carry currencies such as the Mexican peso, so this is where we should look for a rotation in favor of the dollar.”

Neil Shearing, chief economist at Capital Economics in London:

“Our sense is that events in the Middle East will increase the reasons for the Fed to take a more cautious approach to rate cuts, but they will not prevent rates from being cut altogether. We expect the first move in September. And assuming energy prices do not rise in the coming months, we think both the ECB and the BOE will cut in June.”

–With assistance from Macarena Muñoz, Allegra Catelli, Alice Gledhill and Anthony Di Paola.

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