Markets react to developing Middle East conflict

The conflict between Israel and Hamas entered a third day on Monday, after the most serious cross-border attack on Israel in decades. The government of Israel said its military had bombed more than 1,000 targets in Gaza overnight on Sunday, responding to the operation by Hamas-which was launched on Saturday. The US confirmed it is sending warships to the region.

The conflict has led to a risk-off mood in markets. The price of Brent rose as much as 5% before giving back part of this advance to stand 2.7% higher at USD 86.91. The rise reflects concerns that an escalation of the conflict could disrupt oil supplies, particularly from Iran. The move followed an 11.3% fall in the oil price last week.

Equity markets came under pressure. S&P futures declined 0.6%, the Euro Stoxx 50 index fell 0.5%, and China’s CSI Index slipped 0.1%. By contrast, safe-haven assets broadly gained ground. The price of gold climbed around 0.9% to USD 1,849 an ounce. The US dollar, traditionally a refuge during periods of heightened geopolitical tensions, rose modestly. The DXY dollar index, which tracks the US currency against six major peers, gained 0.4% to 106.4. Trading in US Treasuries is closed for the Columbus Day holiday.

What do we expect?

Looking ahead, we see potential for three broad scenarios:

• De-escalation. The best outcome, from a humanitarian perspective, would be a swift cessation of current hostilities. Geopolitical risk premiums in markets tend to fade quickly and would likely do so in the event of a swift de-escalation.
• Contained confrontation. The conflict could prove more protracted, but remains confined to a confrontation between Hamas and Israel in the geographical areas under their respective control. The impact on global financial markets is likely to gradually fade under this scenario, but with the potential for a longer-lasting impact on local markets and assets.
• Regional escalation. In a downside scenario, the conflict could expand to draw in other nations, with the potential for greater disruption to oil supplies. The risks of the conflict dragging in Iran have increased, in our view. Despite US sanctions on Iran, its crude production has recovered to above 3.1mbpd, a five-year-high, with exports running at around 1.5mbpd. In an already undersupplied oil market, disruptions to Iranian exports either through broadening conflict or tougher sanctions could have a significant impact on oil prices in the near term. Market participants are likely to watch for developments that might prompt the US administration to enforce stronger sanctions on Iranian crude exports. There is also considerable uncertainty around Saudi Arabian supply, about whether it would relax its own production curbs to balance the market in the event of lower Iranian exports, or whether its own production could be directly impacted. Over the weekend, key energy ministers from OPEC+ reiterated their commitment to taking additional measures at any time to support the oil market’s stability.

How do we invest?

The latest conflict in the Middle East comes at a time of already elevated geopolitical tensions, with the ongoing war against Ukraine, and the intense geopolitical rivalry between the US and China. At the same time, markets face a period of moderating global economic growth.

Against this backdrop, we continue to prefer fixed income to equities. We see a better risk-reward profile for fixed income, and we recommend investors consider buying high-quality bonds in the 5–10-year maturity range. We foresee further cooling in inflation and slower global growth. Our 12-month forecast for the 10-year US Treasury yield is 3.5% in a base case, 4% in an upside scenario, and 2.75% in a downside scenario, which includes a US recession.

We were already positive on oil prices, due to constrained global supplies and rising demand. Following a sharp drop in US crude oil prices last week, driven by rising US interest rates and re-emerging recession fears, Hamas’ surprise attack on Israel has pushed up oil prices on Monday. While oil production in the Levant region is small and there have been no reported supply disruptions so far, concerns of a further escalation have lifted oil prices. We continue to recommend risk-taking investors add long exposure via longer-dated Brent contracts, which are trading at a discount to spot prices, or to sell Brent’s downside price risks.

On gold, the precious metal has been coming under pressure recently. The metal's price typically declines when risk-free rates rise and when the US dollar strengthens, which raises the price for non-dollar investors and so suppresses demand. With opportunity costs for gold on the rise, we now also see a more constrained outlook for gold, with the metal ending the year around USD 1,850 from USD 1,950 previously and rising to USD 1,950 by the end of June 2024, down from USD 2,100 previously. But we have stressed that gold continues to have diversification benefits in a portfolio, and often outperforms in periods of elevated geopolitical risks. Those who are long gold should hold these positions in anticipation of a recovery over the next 6–12 months, in our view.

The near-term outlook for the US dollar has been helped by the recent strength of US economic data-especially relative to its peers-along with the potential for Federal Reserve rates to stay higher for longer. Despite its structural overvaluation, we expect the US currency to be well-supported for the remainder of 2023. The dollar is also considered a safe haven during periods of geopolitical uncertainty, along with the Swiss franc and the Japanese yen.