Capital Markets exhibit resilience in wake of U.S.-Iran tensions

Markets and investing
1.08.20

U.S. and Iran trade military responses

Oil prices reflect calm, not shock

Recent events in the Mideast have reminded investors of ongoing geopolitical risks in this important oil-producing region. Tensions between the U.S. and Iran remain high but the capital market response has been muted and we don’t foresee an oil shock that would change our market narrative at this time.

Geopolitical uncertainty is something we monitor and have dedicated personnel on our team focused on political risks and considerations. We remain glass-half-full with respect to corporate earnings growth and consumer sentiment based on very low borrowing costs and reasonable wage growth, but that formula becomes cloudier with more frequent military conflict. We caution investors against guessing about retaliatory actions and making investment decisions based on such guesses.

What happened

Last night, at least a dozen ballistic missiles originating in Iran struck two American bases in Iraq. Current reports say that there were no U.S. or Iraqi deaths or casualties. The Iranian attack was in response to a U.S. strike outside of the Baghdad International Airport last week that killed Qassem Soleimani, a top Iranian general, and Abu Mahdi al-Muhandis, deputy commander of an Iraqi militia affiliated with Iran.

In a heartbreaking twist, a Ukrainian Boeing 737, heading from Tehran, Iran to Kyiv, Ukraine, crashed last night shortly after takeoff killing all 176 passengers aboard, including 63 Canadians. The cause of the crash is unknown at this time but the human tragedy compounds the increased tensions in the region.

After an initial surge in oil prices and drop in equity market futures prices late last night, the capital market response to recent events has been notably calm. Oil prices as measured by West Texas Intermediate Crude have fallen back toward $60 per barrel. The price of U.S. treasury bonds, considered a haven in times of crisis, are modestly lower (meaning yields are higher), and U.S. equity prices are slightly higher.

What comes next

According to reports, the Iranian strike did not harm any Americans. While the absence of U.S. casualties could mitigate a dramatic escalation of conflict between the U.S. and Iran, we see two key issues to watch in this regard:

First, is this attack Iran’s only retaliation or will additional, more deadly attacks be forthcoming? Second, the path forward will also depend on the White House response. President Trump made a statement today announcing further sanctions on Iran. While he announced no plans for further military escalation, the full White House response could take weeks to develop.

Capital market implications

If further escalation were to occur, the biggest issue for us would be a sustained rise in oil prices above $70 per barrel, which we have not seen since 2014. Higher energy costs serve as a tax on businesses and consumers, with some estimates that the average household spends around 4-5 percent of their budget on gasoline for transportation and more for heating and cooling their residences.

Oil prices could rise sharply if an attack occurred on infrastructure in the region, such as Iran mining the Strait of Hormuz, dramatically curtailing the flow of oil. According to the U.S. Energy Information Administration, roughly 20 percent of oil traded worldwide passes through the Strait, with 85 percent of crude oil exports from the region bound for Asian markets such as Japan, India, South Korea and China. It is arguable whether Iran could mine the Strait enough to shut it down entirely. If Iran successfully did so, the global economy could suffer from an oil price shock which would curtail the re-acceleration in economic data we are seeing in the U.S. and emerging markets (particularly in oil importing countries such as South Korea).

We are expecting inflation to rise temporarily through the first half of this year, but an oil shock would have two impacts. First, it would serve as a direct input cost to consumers and businesses for transportation and heating or cooling physical properties. Second, an oil shock could push up borrowing costs as central bankers look to guard against inflation by raising interest rates; investors demand more compensation from fixed bond payments in the form of higher interest rates.
In the absence of further escalation from either Iran or the U.S., we continue to expect a mild increase in both oil prices and inflation levels and do not foresee an oil price shock scenario that would change our market narrative at this time.

We will continue to monitor fast-moving events and will update you accordingly. Weighing the risks and based on incoming data, we continue to hold a balanced view of the path forward for investors with a bias toward a pro-growth portfolio orientation. As such, we think remaining diversified across asset classes and disciplined within your financial plan continues to be the best strategy for you. Please do not hesitate if we can answer any questions. We thank you for your trust.