January 29, 2020
Global financial markets have remained relatively calm and the focus has shifted back to global oil demand following the tensions between the U.S. and Iran early this year, but geopolitical risks remain elevated and tensions between the two nations are set to persist. The U.S. has called for further sanctions on Iran, while Iran has threatened to leave the Nuclear Non-Proliferation Treaty (NPT). In this report, J.P. Morgan Research looks at what these risks could mean for oil, gold and equity markets in 2020.
Tensions between the U.S. and Iran escalated dramatically at the start of the year following a U.S. air strike in Iraq, targeting top Iranian general, Qassam Soleimani. Iran retaliated with missile strikes on two Iraqi bases that housed U.S. forces, initially sending Brent crude to an intra-day high of $71.75 per barrel. Oil prices have since receded and the market response remains muted. While J.P. Morgan Research has not altered its baseline recovery scenario for 2020, the primary barometer of market volatility from escalating U.S.-Iran tensions would be through oil prices and overall risk sentiment. The interruption of Libyan oil exports is providing some support for global oil prices, with Brent trading around $60-$65 per barrel and J.P. Morgan commodity strategists have left their oil price forecasts unchanged, given spare capacity and limited signs of additional escalation.
“Geopolitical risks remain elevated, but we maintain our Brent oil price forecast of $67 per barrel for the first quarter of 2020 and are assuming Brent crude oil prices average $64.5 per barrel this year on limited signs of additional escalation. Obviously, oil price risks are to the upside as U.S.-Iran-Iraq tensions are unlikely to fully dissipate,” said Head of Emerging Markets Economics and Commodities Research at J.P. Morgan, Jahangir Aziz.
While the escalation between Iran and the U.S. using conventional military force appears to have reached a relative climax, Iran could potentially continue its retaliation through a covert, low intensity strategy. This could involve possible attacks on oil facilities or shipping lanes in the region, cyberattacks, threats to overseas U.S. military installations or diplomatic personnel, or other indirect tactics. European signatories of the Joint Comprehensive Plan of Action (JCPOA) have invoked the dispute resolution mechanism in response to Iran’s lifting of limits on enrichment in its nuclear program. At the end of a six-step process which could last for two to three months, U.N. sanctions on Iran could ‘snap back’ even though there is unlikely to be unanimity in the Security Council.
“There are strong incentives for both sides to avoid escalating the conflict further, but markets should be prepared for more sanctions on Iran. In addition to the possibility of U.N. sanctions, we see two tracks of U.S. sanctions as possibilities, including sanctions without waivers and secondary sanctions on countries doing business with Iran,” said Joyce Chang, Chair of Global Research at J.P. Morgan.
Concern surrounding supply vulnerabilities is another factor, which is unlikely to abate. With over 20% of global oil supply passing through the Strait of Hormuz, it is seen as the most important oil shipping chokepoint in the world, according to the US Energy Information Administration (EIA). A large-scale disruption, like a blockade of the Strait of Hormuz, could likely boost oil prices 21% and add $14 a barrel to the baseline. Short-lived disruptions to Kurdistan oil production, or a military assault on Iran, would warrant a $1 per barrel risk premium to any baseline forecast, while a wider internal conflict in Iraq could potentially destabilize 4 million barrels per day of physical oil supplies, warranting a $5 per barrel premium.
“While short-term swings in oil prices are not likely to impact global activity, a sustained move in oil prices can impact inflation and growth. A significant escalation in the U.S.-Iran conflict that disrupts production for around six months would mark a material headwind to global growth. A conflict that shut the Strait of Hormuz for a sustained period would likely be recessionary,” said Joe Lupton, Senior Global Economist at J.P. Morgan.
An escalation in the conflict could also weigh on global growth, due to higher oil prices and general de-risking from investors. In the event of a sustained $10 per barrel increase in oil prices for a year, due to a supply-led shock, it could lead to a 0.15% drag on global growth, according to J.P. Morgan Research. However, J.P. Morgan economists continue to see geopolitics as a limited threat, as oil supply stress is buffered by Organization of the Petroleum Exporting Countries (OPEC) spare capacity, existing inventories and U.S. shale.
More broadly, global oil markets are experiencing unprecedented resilience. Saudi Arabia succeeded remarkably well in restoring capacity after the attack on its oil facilities last September, while U.S. production is also providing a whole new level of liquidity to the markets, in addition to the spare capacity in OPEC+ nations.
Despite a stellar 2019, where global equities delivered a near 30% return, J.P. Morgan Research remains bullish into 2020. Though there is a potential for an escalation in Iran-U.S. tensions which could lead to a risk-off move, historically temporary geopolitical conflict, as well as terrorist incidents, have tended to cause a transitory and typically limited impact on equities.
“At the overall market level, we do not think that the latest round of U.S.-Iran tensions derails our constructive view. Yes, the knee-jerk reaction to any escalation is a risk-off move, but episodes of geopolitical uncertainty have historically been buying opportunities, rather than the reasons to start selling, as any resulting market weakness tended to be short lived,” said Mislav Matejka, Head of Global Equity Strategy at J.P. Morgan.
Source: J.P. Morgan Equity Strategy
In the current environment, the energy sector could be a useful hedge. It was among the worst performing sectors in 2019, diverging from the performance of the oil price and the energy sector remains extremely cheap on most valuation metrics.
“We believe the gap should close with energy relative moving higher,” added Matejka.
Gold prices hit their highest level since 2013, climbing briefly to $1,600 a troy ounce before settling back to $1,560 as tensions in the Middle East fueled demand for safe haven assets.
“The risk premium boost to gold prices during Middle East military conflicts, while sizeable (5-10%), has typically ultimately proved fleeting. We maintain our gold price forecast of $1,500 per troy ounce for the first quarter and $1,550 per troy ounce for the second quarter of 2020,” said Natasha Kaneva, Senior Commodities Strategist at J.P. Morgan.
As the threat of immediate conflict has subsided for the time being, fundamental drivers, like low U.S. real yields given a forecasted second quarter Federal Reserve cut and the ongoing shift towards average inflation targeting, should re-establish themselves as the primary catalyst for prices.
In terms of valuations, the current spot gold price appears about $130 per troy ounce rich relative to real yields according to J.P. Morgan data - not far from the $150-160 per troy ounce reached at the peaks of previous premium expansions.
This communication is provided for information purposes only. Please read J.P. Morgan research reports related to its contents for more information, including important disclosures. JPMorgan Chase & Co. or its affiliates and/or subsidiaries (collectively, J.P. Morgan) normally make a market and trade as principal in securities, other financial products and other asset classes that may be discussed in this communication. This communication has been prepared based upon information, including market prices, data and other information, from sources believed to be reliable, but J.P. Morgan does not warrant its completeness or accuracy except with respect to any disclosures relative to J.P. Morgan and/or its affiliates and an analyst's involvement with any company (or security, other financial product or other asset class) that may be the subject of this communication. Any opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This communication is not intended as an offer or solicitation for the purchase or sale of any financial instrument. J.P. Morgan Research does not provide individually tailored investment advice. Any opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. You must make your own independent decisions regarding any securities, financial instruments or strategies mentioned or related to the information herein. Periodic updates may be provided on companies, issuers or industries based on specific developments or announcements, market conditions or any other publicly available information. However, J.P. Morgan may be restricted from updating information contained in this communication for regulatory or other reasons. Clients should contact analysts and execute transactions through a J.P. Morgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise. This communication may not be redistributed or retransmitted, in whole or in part, or in any form or manner, without the express written consent of J.P. Morgan. Any unauthorized use or disclosure is prohibited. Receipt and review of this information constitutes your agreement not to redistribute or retransmit the contents and information contained in this communication without first obtaining express permission from an authorized officer of J.P. Morgan.