Written by LGT Crestone Senior Asset Allocation Specialist Matthew Tan
On 7 October 2023, the Palestinian military group, Hamas, launched a co-ordinated assault on Israel across multiple points. This was the largest attack on Israeli soil in decades, and culminated in the killing of hundreds of civilians and the kidnapping of an unknown number of Israeli soldiers and citizens. In this Special report, we outline the signposts that investors should be monitoring with regards to this situation and the potential impact on markets and economies.
The attack has come a day after the 50th anniversary of the 1973 Yom Kippur War. It has sparked a ferocious response from Israel, which has declared war and launched extensive (and escalating) military operations in response.
The situation is still very fluid, with significant questions around (i) how the attackers evaded Israel’s extensive defences and intelligence capabilities, (ii) the extent of the initial attack and how strong Israel’s response might be, and (iii) whether the conflict is likely to expand beyond Israel-Hamas to include other regions, such as Iran and/or Saudi Arabia.
In the past, conflicts within the Gaza Strip between Israel and Hamas have had limited implications for the global economy and markets. However, we believe that risks of this conflict escalating and expanding are elevated compared to prior clashes between the two parties. Reasons for this include:
Taken together, these domestic political constraints likely tilt risks towards further escalation in the conflict, at least for a time. Israeli officials are overtly signalling this, with Prime Minister Netanyahu pledging “mighty vengeance” and an Israeli military spokesperson saying that “this is going to be a long, long haul”.
The key downside risk for economies and markets is an escalation of the conflict to include other major countries in the Middle East, particularly Iran (which has historically backed both Hamas and Lebanon-based Hezbollah).
In a worst-case scenario, an Israeli reprisal that brings it into conflict with Iran risks a blockade of the Strait of Hormuz and significant disruption to global oil supplies, which would put further upward pressure on oil prices and headline inflation. This could also present challenges for central banks and how they respond.
There are further potential flow-on effects—an extended, potentially escalating conflict could put further pressure on Western munitions stockpiles, which are already depleted after 18 months of conflict between Russia and Ukraine. It would also further occupy US (and NATO) attention and capacity, reducing the West’s ability to respond to any further crises (for example, in the Korean Peninsula).
The two key channels of potential transmission are a spike in oil prices and/or oil supply disruptions; and/or significant market volatility and/or impacts on risk sentiment that flow through to the real economy.
In general, markets are poor at both pricing and responding to geo-political shocks, so we would expect a period of significant volatility in the coming days and weeks as markets digest these developments and consider the potential implications. We also expect the potential for some overshoots on both the upside and downside.
Looking beyond this immediate horizon, financial markets actually tend to rise in the six to 12 months following the outbreak of conflicts and crises. However, we note two key exceptions:
1. Most importantly, markets tend to perform poorly if an endogenous recession occurs following the event. This is a key risk today, because as we have noted in recent months, a combination of tight monetary policy, high bond yields, and poor consumer sentiment were already pointing to some risk of a recession occurring.
2. If the war leads to or coincides with an oil shock (e.g. the 1973 Yom Kippur War), this tends to be stagflationary and hurts both financial assets and the real economy.
These two exceptions provide us with some useful signposts to monitor the outlook. In particular, we are closely monitoring for any signs that:
It is still early days and the situation on the ground and in markets remains very fluid. We expect that this uncertainty will prevail for some time. As such, we are focussed on improving our understanding of the key uncertainties and signposts and assessing the likely implications for markets and economies, as well as how we can best steward clients’ portfolios through this period with a steady eye on long-term objectives.
As we enter this period of uncertainty, we are broadly comfortable with our current portfolio positioning, where we are overweight fixed income and neutral equities. If the conflict escalates and/or our judgement of the other signposts points to increased downside risks, we are prepared to adjust our exposures as necessary. In a downside scenario, we favour:
Beyond this, as markets digest developments, we are maintaining a flexible and nimble approach to our tactical asset allocation, and will take advantage of any potential overshoots (in both directions) across financial markets as and when they occur.
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