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Institutional Perspectives

What should investors be focused on amid the current conflict?

In following the recent escalation in tensions between the United States and Iran, and their impact on financial markets, one development on January 8 was particularly striking. If a person in the eastern United States went to bed on the night of January 7, without having scanned the news, and then checked global financial market indicators the next morning without reading the headlines, they would think that not much had happened overnight. Of course, that’s when Iran launched a retaliatory missile attack on U.S.-shared military bases in Iraq.

Why might the market reaction have been so muted? It all comes down to the price of oil. In our view, the financial market contagion from global crises, particularly those involving the Middle East, is always going to be through a sharp rise in crude oil prices. Higher energy prices typically crimp consumer spending, which leads to slowing economic growth. (Those who lived through the 1970s remember that well.) If oil prices stay stable, people don't have to spend more on gasoline, or heating oil, or other energy-related goods and services.

How does this relate to the market reaction on January 8? In the immediate aftermath of the attack, oil prices shot higher. Once investors assessed the situation more fully, and decided that tensions were not likely to escalate meaningfully in the immediate term, the perceived threat to global oil supplies diminished, and crude prices came back down. In our opinion, the lesson here is: If oil prices don't go up, even the most alarming geopolitical flare-ups are not likely to filter through to the global economy in a way that’s negative.

In the hierarchy of concerns occupying investors right now—the shape of the U.S. yield curve, the health of the 10-year U.S. economic expansion, and so forth—geopolitical risk has moved front and center. And the financial market expression of geopolitical risk is the price of petroleum. To be sure, the U.S.-Iran standoff is in its early days, and conditions could worsen significantly. But if oil prices don’t go up, the current crisis likely will be limited in its ability to hurt markets.

 

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