New year, new wild card
Heightened tensions between the United States and Iran have brought a new wild card for investors this year. Read our take on why we don’t think recent events should derail your investment plan.
Our Top Market Takeaways for the week ending January 10, 2020.
Markets in a minute
Too soon to say
Being only one week into the year, it’s probably too soon to say that anything is a defining “trend” of 2020. That said, tensions in the Middle East have clearly dominated the investment narrative so far.
As a quick recap, long-strained relations between the United States and Iran began worsening a few weeks ago. At the end of last week, the United States killed Iran’s Quds Force commander, General Qasem Soleimani. Iran retaliated against the United States earlier this week by conducting missile strikes on two Iraqi military bases hosting American troops (no Iraqi or American lives were lost).
Amid these developments, assets’ knee-jerk reactions were as you would expect them to be. Supply disruption concerns drove the price of oil higher, with Brent crude jumping above $71 per barrel. Safe haven assets like Treasuries and gold rallied, with the latter reaching its highest price since 2013 ($1,611 per ounce). Equities overall got spooked and moved lower, but not without some notable dispersion. Stocks in countries like India and Japan, both of which rely heavily on purchasing oil from other countries, lagged global equities; stocks in Russia, which is a large exporter of oil, outperformed. At the sector level, the moves were similarly logical: Companies with meaningful exposure to fuel costs (airlines, for example) were among the hardest hit, while energy companies were among the best performers.
This type of initial risk-off reaction is typical, but markets have already started to calm down and reverse their moves from just a couple of days ago. Heading into Friday, the S&P 500 is up +1.2% on the week, 10-year Treasury yields are back above where they started on Monday (currently at 1.85%), gold is trading around $1,550, and the price of Brent crude has settled down to around $65.50/bbl. Given that both the United States and Iran have relayed that they’re keen to avoid further military escalation, this kind of quick recovery is in line with what we would expect. Read on for our explanation as to why.
The Iran wild card
Whenever a geopolitical event comes to the fore, our first order of business as investors is to look for any link between the event itself and its impact on the broader economy and markets. And in regard to the recent flare-up in tensions between the United States and Iran, the most obvious potential impact would be a disruption to the world’s oil supply. From there, the story goes that such a disruption could catalyze substantially higher oil prices and lead to higher inflation. But spoiler: We don’t think that’s how things will play out today, and the fundamentals of the oil market look pretty balanced (and by our estimations, even slightly oversupplied).
When it comes to understanding oil prices, three dynamics are important: 1) the balance between supply and demand, 2) inventories, and 3) investor positioning. Let’s dig into each.
- Supply and demand: A balancing act. When the recent attacks occurred, investors’ worries centered around the supply side of this equation—in other words, that the conflict could play out in a way that would take significant oil supply offline and dramatically increase oil prices. As we know now, there hasn’t been a direct disruption to oil production that would make that the case. Even so, such an event might not even have extreme consequences today for a few reasons. For one, the United States has grown increasingly more important to the oil industry and now supplies more than any other country; this lessens the potential impact a disruption in the Middle East might have on the overall oil market. Additionally, much of Iran’s oil supply has already been restricted as a result of the reinstitution of U.S. sanctions in 2018—so supply that would have otherwise been at risk in Iran has already been taken off the table and accounted for by markets. On the demand side, global economic activity is only just starting to inflect higher, suggesting crude demand growth isn’t about to stabilize anytime soon. Add all this up, and we actually expect the oil market to be in a small supply surplus by the end of this year.
There are certainly risks to this view, as other oil-producing areas of the Middle East could prove vulnerable if further retaliation occurs and tensions spiral. Should those retaliatory actions actually target oil facilities in the Persian Gulf (where Western firms have been investing in new production), or pipelines or shipping areas by the Strait of Hormuz or the Red Sea, we could see a more notable impact on oil production. That’s not our base case at this time, but we do acknowledge that it’s a risk.
- Inventories: Taking stock. Inventories are the actual barrels of crude that oil producers, firms and governments hold in reserve. These reserves, or stockpiles, are often used to smooth the impacts of supply and demand—when inventory levels are higher, it could be a sign that supply exceeds demand, pushing oil prices lower; and when inventory levels are lower, it could be a signal that demand is increasing, bidding prices up. Right now, inventories are still pretty elevated, which should keep oil prices from sprinting higher.
- Investor positioning: It’s all in how you see it. Investor positioning refers to whether investors’ views on the price of oil are more bullish (optimistic) or bearish (pessimistic). Right now, more investors seem to be buyers of oil than sellers, largely as a result of the Saudi oil facility attacks back in September. Before last week’s events, the market seemed to be underpricing geopolitical risk, but following the recent leg higher in prices, we think there’s now a healthy amount of geopolitical risk already reflected in current oil prices.
All this goes to say that the tensions between the United States and Iran do not change our views, and from a market standpoint, the impact of the latest events are already fading. Using history as a precedent, in an overwhelming majority of past geopolitical conflicts (from the Cuban Missile Crisis to the U.S. invasion of Iraq in 1991 or 2003, to the Russian invasion of Ukraine in 2014), the event itself tends to have a fleeting impact on markets. In the context of our 2020 Outlook, this geopolitical event is similar to other “wild card” scenarios that we are prepared for, and we don’t believe this should derail your investment plan.
All market and economic data as of January 2020 and sourced from Bloomberg and FactSet unless otherwise stated.
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