OCBC OneWealth App– New year, old enemy

Economics

Equities

Global

Outlook

US-Iran tensions

New year, old enemy

7 January 2020

Rattled nerves, or an excuse to take profit?

With stocks trading at all-time highs, investors needed a reason to take profit and the US-sanctioned airstrike that killed top Iranian military general Qassem Soleimani provided a convenient excuse to do just that.

The first geopolitical risk event of the year saw US stocks retreating 0.7 to 0.8 percentage points, the most over the past four weeks. As expected, safe havens gained, with gold adding about 4% and the Japanese Yen falling to its lowest point since early October last year. Oil prices surged more than 3% on the potential risk of an all-out military conflict between the US and Iran.

An escalation for sure

To be clear, the assassination of Iran’s top military general is a major escalation in the US-Iran saga.

For one, it triggered Iran to pull back from the 2015 nuclear accord altogether, unshackling them from terms limiting their ability to enrich uranium.
Second, the killing of a top-ranking personnel, who was arguably a respected figure in Iran, has united its people against the US. Public cries to end sanctions and improve rocky relations with the US was the chief reason behind President Hassan Rouhani’s willingness to negotiate the nuclear deal back in 2015. A decisive flip in public sentiment against the US could lead to a more belligerent Iranian government.
Third, a retaliation is almost a question of when rather than if. A seemingly untethered and belligerent Iran could well mount a disproportionate response.

Bellicose rhetoric on both sides have aggravated tensions. For his part, President Donald Trump has promised to strike “in a disproportionate manner” and attack 52 identified Iranian targets, including important cultural sites, if Tehran dared retaliate.

Will this be enough to force Iran to back down, or at least temper the scale of their response?

All eyes on oil

Suppose it isn’t and Iran mounts military attacks on US assets and citizens in the Middle East or blocks traffic across the Strait of Hormuz, a narrow waterway where tankers carrying most of OPEC’s (Saudi Arabia, Kuwait, Iraq, Iran) oil exports must cross to leave the Persian Gulf. Retaliation from the US is likely to be swift and an outright war might ensue. Notably, Iran is four times larger than Iraq. If the US-Iraq war was disastrous, a US-Iran showdown might be near catastrophic. This would lead to a sharp rise in oil prices and trigger a flight to safety, as investors will likely flee risky assets for the security of haven assets like gold and the Japanese Yen.

A sustained spike in oil prices due to supply disruptions is a concern as such price spikes tend to precede a recession. It hurts not only businesses which depend on crude derivatives for their operations, but also threatens consumption spending. Higher gasoline or petrol prices decrease consumers’ disposable income and stifle consumption, effectively hitting a key engine of US growth. A war, or a tit-for-tat military conflict, will also increase geopolitical uncertainty and weaken business sentiment, further dampening investment spending.

The possible inflationary consequences of higher crude prices would leave central banks with little room for more accommodation. Even if central banks were willing to look past temporary spikes in inflation, the mini-monetary easing cycle of 2019 necessarily means they have limited ammunition left to respond decisively and sufficiently to a potential slump in aggregate demand.

Fortunately, there is a mitigating force that might restrain the rise of crude prices. This comes in the form of US shale oil producers. Unlike the 1970s, 1980s and 1990s when the Middle East dominated oil supply, shale oil producers have become a major producer in the global oil markets. Shale oil production is fairly price elastic, in that production is easily turned on and off in response to moving prices. A spike in oil prices could spur a sharp increase in US shale oil output, which in turn would cap oil price gains and reduce the economic fallout. In fact, markets expect as much, as can be inferred from stable long-dated crude futures.

On the flipside, a less aggressive retaliation by Iran in the form of cyber-attacks on key infrastructure or conventional attacks on various US targets through its network of proxy militias in Lebanon, Yemen, Syria and Iraq might limit the fallout, insofar as it might not provoke a huge military response from the US. The impact on markets is unlikely to be significant and markets will likely regain their footing after a short period of volatility.

Just more sabre rattling for now

For now, it is just a case of sabre rattling. From the outset, it is in the interest of both parties to avoid an all-out military conflict. Iran is certainly aware that the US have the military might and resources to inflict significant damage should they engage the country in an all-out war. At the same time, with this being an election year in the US, President Trump may lean in on his “tough guy” persona and adopt an uncompromising posture in his military response against Iran if the Iranians retaliated too aggressively.

Avoiding a protracted war is to the benefit of all. After all, the war in Iraq offers a valuable lesson about the heavy costs of an outright conflict, a fate Iran would doubtless want to avoid.

Meanwhile, in the US, President Trump would be hard-pressed to drag the military into another war in the Middle East considering he campaigned on the message of avoiding wasteful conflict, unlike his then competitor Hillary Clinton who had voted to go to war with Iraq. This had, in part, contributed to his electoral victory.

Yet, history has shown that presidents tend to enjoy their highest favourability rating during periods of international crisis or war, in what political scientists termed the “rally around the flag” effect. This might help in a presidential election year, as it did President George W Bush in 2004.

It’s difficult to predict where President Trump would land between these two polar scenarios. The hope is that his non-interventionist instinct kicks in to avoid an all-out military conflict. Yet, his sanctioned assassination of a top Iranian official leaves Iran with little choice but to respond. The form of that response will continue to leave markets on tenterhooks.

Still, the likelihood of direct warfare remains low as evidenced by the fact that long-dated oil futures remain stable. This might also reflect the fact that markets believe major producers in OPEC+ and US shale producers could keep the market well supplied and therefore keep prices stable even in a conflict.

There’s something to see here, but don’t get too fixated

US-Iran tensions will continue to lurk in the background and may escalate from time to time. Given recent information, we do not believe this is a major risk in the long term. As long as both countries avoid an outright war, the economic fallout should be limited and well-contained. There will be bouts of risk aversion and flights to safety during periods of escalation, but on a longer-term view, the bull is expected to continue charging ahead.

Important Information