ClockWise: Geopolitical tensions return but markets may be underpricing risk

This weekend’s horrific attacks on Israel have put the country on a war footing which has the potential to expand beyond Gaza to Iran if direct support for the Hamas operation can be proved.

The Gaza Strip is roughly the size of Isle of Wight but with the population of Birmingham. An Israeli military incursion into such a densely populated area could lead to significant further loss of life and a ratcheting up of tensions with neighbouring states.

The greatest risk to the world economy and financial markets would be from open conflict with Iran, given the importance of the Straits of Hormuz to the global supply of crude oil and given Iran’s close relations with Russia, as illustrated by their provision of attack drones used in Ukraine. Initial market reaction has been limited to a small rise in the oil price and a mild sell-off in stocks, but the situation could develop in several ways causing a global impact, so a cautious reaction from markets has not been a surprise.

The base case scenario for investors appears to be that of a dangerous and unpredictable situation but with tensions gradually reducing over the next few weeks and months. If this proves the case, financial market impact will remain limited.

A more serious regional conflict could trigger a sharp rise in energy prices, however, boosting inflation and triggering additional central bank rate hikes, as we saw after the Russian invasion of Ukraine. Our Investment Clock links the global business cycle to asset rotation. We’d describe this scenario as a move from disinflationary Recovery into Overheat, with commodities most likely rising and bonds continuing to sell off (Chart 1).

A more extreme scenario with US involvement in a wider conflict could result in a drop in consumer confidence worldwide, plunging economies into recession. This would probably trigger a move into Stagflation on the Clock, with stocks in a new bear market until the situation improved.

It will take some time before it is clear which way things are moving. In the meantime, it may make sense to be a little more cautious on stocks, a little more positive on commodities, and to add to safe-haven investments including gold, defensive equity market sectors, the Japanese yen and the Swiss franc. The market may be under-pricing risk.

Chart 1: Investment Clock heading out of Recovery, but where next?

Source: Royal London Asset Management. Clock trail shows the evolution of our proprietary growth and inflation indicators over time.

Last week’s market summary

Global stocks and bonds fell as the ‘higher for longer’ interest rate narrative continued. The S&P 500 recorded its first negative calendar quarter since the third quarter of 2022. Bond markets sold off once again as nominal and real rates continued to rise, with the US 30-year bond yield briefly hitting 5.0% for the first time since 2007. Despite higher prices in the energy and base metal complex, commodities fell at the broad level led by precious metals and agriculture. We saw strength in the US dollar, for the 11th consecutive week, while sterling moved off its lows and the euro fell.

Last week’s economics

Global growth looked soft, judging from business confidence surveys, but US data came in on the strong side of expectations with a big payrolls number supporting for the ‘high(er) for longer' narrative. US inflation indicators were a bit less worrisome though.

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