Markets weighs risk of retaliation-cycle after Iran's air strike on Israel

By Srinivasan Sivabalan, Ye Xie and Thyagaraju Adinarayan

Financial markets will face the new week fretting about geopolitics with much riding on whether Iran’s unprecedented weekend strike on Israel triggers rounds of retaliation.
 

With investors already rattled by sticky inflation and the prospect of higher-for-longer interest rates, the escalation of the Middle East crisis is set to inject fresh volatility when trading resumes.

When Hamas attacked Israel in October, the biggest fear for many market participants was that Iran would ultimately be drawn into the fighting. Now as the conflict widens, many say oil could surpass $100 a barrel and expect a flight to Treasuries, gold and the dollar, along with further stock-market losses.

 

A spike in nerves may still be tempered by the flight to safety in markets on Friday in anticipation of a strike, Iran’s statement that “the matter can be deemed concluded” and a report that President Joe Biden told Israeli Prime Minister Benjamin Netanyahu that the US won’t support an Israeli counterattack against Iran.

“Investors’ natural reaction is to look for safe-haven assets in moments like this,” said Patrick Armstrong, chief investment officer at Plurimi Wealth LLP. “Reactions will be somewhat dependent on Israel’s response. If Israel does not escalate from here, it may provide an opportunity to buy risk assets at lower prices.”

Bitcoin gave an early insight into market sentiment. The token sank almost 9% in the wake of the attacks on Saturday, only to rebound on Sunday and trade near the $64,000 mark. 

Stocks markets in Saudi Arabia and Qatar posted modest losses under thin trading volumes. Israel’s equity benchmark fluctuated between gains and losses at least nine times before closing with a small gain.

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

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

While the conflict in the Middle East hasn’t yet had any impact on production, Red Sea attacks by Iran-backed Houthis in the Red Sea have disrupted shipping. Traders mostly fear a widening conflict could disrupt tanker shipments from the Persian Gulf through the Strait of Hormuz.

Worries about turmoil in the region have also been filtering through global markets. The S&P 500 is coming off its biggest weekly decline since October on the back of higher-than-expected inflation and disappointing bank earnings. 

In the bond market, traders will be weighing the risk that more expensive energy bills may add to swirling inflation fears. While Treasuries tend to benefit in times of uncertainty, the threat of interest rates staying high could limit moves. US equity and bond futures will open at 6 p.m. New York time Sunday.  

Meanwhile, gold has been on a tear, gaining 13% this year to hit 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, the best performance since late 2022. 

Here’s what investors and analysts are saying: 

Erik Meyersson, chief emerging markets strategist at SEB:

“Our oil analysts do not see much sign of a geopolitical risk premium in oil prices so far. We expect this to reflect market perceptions of low risks of escalation up until now. This equilibrium is likely to be tested if Iran and Israel continue to attack each other.”

Gonzalo Lardies, senior equities fund manager at Andbank:

“A new environment of uncertainty is now opening up, but the market on Friday already partially priced in this situation, so if it does not get worse the impact should not be very high. The risk is if this situation escalates and there is contagion in the region.”

Alfonso Benito, chief investment officer at Dunas Capital:

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

Joachim Klement, a strategist at Liberum:

“The reaction will very much depend on the reaction of Israel today and whether the US can manage to restrain Benjamin Netanyahu.”

“In the next couple of days, stock markets will focus on the geopolitical situation, rather than central bank action or the strong economy in the US. Hence, we expect the rally to stall until there is more clarity if the situation in Iran-Israel calms down. If we end up in a shooting war between Israel and Iran, then the rally will be stalled for longer.”

Mark Matthews, strategist at Bank Julius Baer in Singapore:

“The good thing is that Iran did warn about the attack well beforehand. Military analysts say it was done in a way that minimized casualties. I don’t see why it would cause Fed rate expectations to fall more or it would cause the oil price to go up a lot. Iran is trying to defuse this and so is the US. The key is what Israel’s answer will be, and then Iran’s answer to that. If Israel does a de-escalatory strike, and then the Iranians do an even more de-escalatory strike, then it will be over with.”

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

“There is scope for further accumulation of dollars, even with recent buying after the CPI data. Our clients remain overweight the euro, Canadian dollar and some high-carry currencies such as the Mexican peso, so this is where we would watch for rotation in the greenback’s favor.”

Neil Shearing, chief economist at Capital Economics in London: 

“Our sense is that events in the Middle East will add to the reasons for the Fed to adopt a more cautious approach to rate cuts, but they won’t prevent it from cutting altogether. We expect the first move in September. And assuming that the energy prices don’t spiral over the next month or so, we think that both the ECB and BOE will cut in June.”