Muted market reaction to Iran strike overlooks key uncertainties
Over the last few years markets have been conditioned not to overreact to political and geopolitical shocks for two reasons: first, the belief that there would be no significant subsequent intensification of the initial shock; and second, that central banks stood ready and able to repress financial volatility
The immediate market reaction to the US air strike that killed a top Iranian general was a textbook one, but it also raised short- and medium-term issues that have not been sufficiently internalized by traders and investors. As long as the conflict between the two countries doesn't intensify, market participants will most likely be tempted to quickly brush off the initial risk-off reaction and play down the longer-term issues. That would be understandable, but it would also be too partial a response in balancing favorable short-term market conditions with mounting longer-term uncertainties.
The killing of Qassem Soleimani is a significant escalation in what has been a protracted period of low-intensity tensions and asymmetric warfare. Unsurprisingly given Soleimani's position and standing within the country, Iran's supreme leader, Ayatollah Ali Khamenei, has promised a major retaliation against the US This comes in a region already littered with proxy wars and asymmetric tactics that continue to pull in external actors, including Turkey's decision this week to intervene in Libya.
The market's immediate reaction to this sudden exacerbation of Middle East geopolitical tensions was a predictable one: Equities fell; oil prices soared; and yields on US and German government bonds — traditional safe havens — declined. This is consistent with the higher risks to oil supplies, global growth and consumer and business confidence. Having said that, the magnitude of all three moves was relatively muted, and they were partially reversed as trading fully opened and the session proceeded, with good reason.
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Over the last few years, markets have been conditioned not to overreact to political and geopolitical shocks for two reasons: first, the belief that there would be no significant subsequent intensification of the initial shock; and second, that central banks stood ready and able to repress financial volatility.
Today, the first view draws support from the argument in markets that, rather than viewed as an unprovoked US military action, the air strike was essentially a response to Iranian actions — including attacks on a US drones, a ship, embassy and Saudi oil fields — that was also aimed at pre-empting an imminent Iranian action. With that, the consensus view is leaning more toward a restoration of US deterrence as opposed to an all-out war as the next step. This does not mean that markets are dismissing the possibility of Iranian attacks and further US retaliations. They are not. Rather, they see these as relatively contained and not spilling over into open armed conflict between the two countries.
The second view is confirmed by the continuous expansion in central bank balance sheets, particularly those of the European Central Bank and the Federal Reserve. In addition, the Fed can return to cutting interest rates as it did last year should market volatility increase.
This is not an unreasonable short-term conclusion. But it is also one that is subject to considerable uncertainty, especially given the risk of a miscalculation of either side. Moreover, it glosses over the growing set of challenges facing markets over the longer term. Investors need to balance continued favorable market momentum in the short term with growing uncertainties that encompass not just geopolitics and politics, but also economic, financial and institutional issues.
As tempted as long-term investors will be to again buy the dip, primarily using index and passive products — and they will — they should do so as part of an increasingly more selective overall strategy that maintains a claim on the short-term upside while protecting more against the mounting uncertainties. This includes emphasizing up-in-quality trades that are anchored by robust balance sheets and high cash-flow generation, resisting the strong temptation for large-scale shifts away from US assets in favour of international investments, and reducing exposure to inherently less-liquid market segments that have experienced beneficial spillovers from extraordinary central bank stimulus and the general reach for yield and returns.
Mohamed A. El-Erian, at melerian@bloomberg.net
