Middle East shock will be the difference between a hard and soft landing

Geopolitics have already been casting a long shadow over investors. What happens next with Israel and Iran could have major implications for markets.

Demonstrators wave Iran's flag and Palestinian flags as they gather in front of the British Embassy in Tehran. Picture: AFP

Hold on. This one is going to get rocky. Even before the Covid pandemic, investors have been trying to navigate fast-rising geopolitical tensions. There’s the China-US trade battle, Russia’s invasion of Ukraine and then the Israel-Palestinian conflict. There’s trade sanctions all around. However, Iran’s direct strike on Israel is set to take these stresses to a whole new level.

The big question is what happens next in the Middle East. And the answer to this has big implications for commodities, money markets, equities and everything else in-between.

And unlike previous geopolitical shocks, this time markets are also attempting to work through the invisible force of inflation. Signs that inflation is on the rise in the US again is going to limit any economic response if tensions escalate and global growth slows. Now it’s up to US 10-year bonds to try to make sense of it all.

Traders work on the floor of the New York Stock Exchange as the S&P 500 fell 1.5 per cent on Friday. Picture: AFP

Iran directed missiles and reportedly a hundred drones at Israel over the weekend in retaliation to a reported Israeli strike in Syria that killed a number of top Iranian military commanders. Israel hasn’t commented on the Syrian strike. However, the move marks the first direct confrontation between the two adversaries and sets the already tense Middle East up for a bigger conflict. Much is in the balance with Israel considering how it responds to the missile hit.

Already, safe havens like gold and US treasuries have been surging in the lead up to the weekend strike. One key signal is Iran had thoroughly telegraphed its intention to hit back for the attack on its consulate in Damascus. This became more specific towards the end of last week, with the US getting notice of the “targeted” nature of the intended attack via Iran’s regional allies. Even the actual attack, aimed away from major cities, gave Israel time to prepare. Damage was light, with most weaponry destroyed before hitting Israel. Still, this may not be where it ends.

Asia is the first market to open on Monday, and shares from Australia to Singapore are widely tipped to be sold off as cash moves back into safer places like bonds. Already, US shares are stretched from the massive rally since last October, with the benchmark S&P 500 trading at more than 21-times earnings, the highest level in more than a decade. Even Australian shares are starting to look frothy, trading at a price to earnings ratio of 17-times, well above a longer term average.

The risk premium – mostly built around the tearaway gains of Magnificent Seven members – can be handled if bond yields are falling. But a return to inflation has pushed long-term yields higher, particularly in the past week.

Wall Street’s S&P 500 fell 1.5 per cent on Friday in its worst day in four months, although Australia was more resilient last week. Wall Street’s VIX Index, the so-called fear gauge, is at its highest level since last November.

Missiles were seen in the skies of Rafah, Gaza Strip following the attack from Iran on Sunday. Picture: Getty Images

Gold, regarded as a safe haven, has been surging on rising tensions. There has also been the additional overlay of the US interest rates being on hold. All things being equal, gold has an inverse link to interest rates, that is it should fall as interest rates rise. But ten-year bonds and gold have been rising at the same time, as markets have been quickly paring back their bets the US Federal Reserve is planning successive interest rate cuts this year.

Oil remains the inflationary pinch point, and complicating oil markets in recent months has been the Russia and Ukraine conflict. There, Ukrainian drones have been striking oil refineries deep inside Russia’s borders, including one of the nation’s biggest. In response, Russia has been curtailing oil exports, which means countries including India, which have been buying oil from Russia’s “shadow fleet” of crude tankers have been forced to look elsewhere for supply. Iran too is a major oil producer, and disruption in its capacity to supply markets could push oil even higher.

A broader Middle East conflict would have even bigger implications. The global benchmark, Brent Crude, is back to a six-month high, returning above $US90 a barrel. Even a response from the US that involves a tightening of sanctions on Iran could push up oil yet again. Any further gains in oil could unleash a new wave of energy inflation and have broader knock-on effects for the global economy. US president Joe Biden plans to meet with G7 leaders to consider a diplomatic response to the crisis.

All this will make it tough for central banks to cut rates, given inflation is certain to start pushing up again. Already, markets have been repricing sharply on signs US cash rates are set to remain high for longer. Markets are now pricing just two US rate cuts this year, and this has been delayed to much later in the year. This could be the difference between a hard and soft landing.

And although inflation appears to be moderating in Australia, albeit slowly, it too remains vulnerable to another crunch to the global supply chain. At the same time, it would be very difficult for Australia’s central bank to cut the cash rate ahead of the US, given the likely pressure on the Australian dollar.

The risks are high as Treasurer Jim Chalmers is finalising the federal budget ahead of May 14. Australia is facing a slowing Chinese economy. Chalmers on Sunday acknowledged China is likely to hit this year’s official GDP growth target of about 5 per cent and this is likely to be reflected in the budget. With inflation on the rise again, many countries facing a recession and the stresses on the global economy from the regional conflicts, this means “that the degree of difficulty for this budget is a bit higher even perhaps than the first two,” Chalmers told ABC TV on Sunday.

Even – if by chance – the Middle East steps back from escalation, geopolitical risks remain. The rhetoric is set to intensify in the countdown to this November’s US presidential election, Ukraine is grinding on and China’s economic tensions are real. Markets take these stresses in their stride, trading on what they can quantify and finding a way forward. It doesn’t make it any easier, with a wild ride ahead to be sure.

Originally published as Middle East shock will be the difference between a hard and soft landing