It’s been over three weeks since news broke of Israel-Hamas conflict, and the fallout has continued.
The human toll has been devastating, and as tensions continue, many appear to be questioning the prospect of broader escalation.
Yet, markets haven’t moved as you might expect. Are they ignoring the geopolitical risks?
In short, we don’t think so. Markets seem to be very aware of the conflict unfolding in Israel and Gaza, and are accounting for what’s known so far. Things could change if the situation escalates, but as of now, markets are behaving about in line with past geopolitical events – with greater emphasis on the broader economic backdrop and business cycle.
Today, we take a deeper look at the price action.
The assets closest to the conflict have moved the most.
Since the conflict began and up until the time of writing, Israel’s currency – the shekel – has weakened over 5% versus the dollar, and prices for both oil and safe haven, gold, are around 7% and 9% higher, respectively.
Oil and gold prices reflect some worry, but not meaningful escalation
These line charts show the price of Brent crude oil on the left and Gold on the right,
The left chart showing Brent crude oil prices starts at $73 per barrel at the start of June, and hovers around to $75 level for the first month. Throughout July and the start of August, oil prices surge from below $75 to $88 on August 8. From there, we see a slight pullback to $84 at the end of August before rebounding sharply to a series high of $97 on September 27. Prices then sell off sharply to $85 on the day that the Israel-Hamas War began. Since then, oil has snapped back higher to today’s level at $93.
The right chart showing gold prices starts at $1980 in June and initially falls over the first month to $1907 by June 28. Gold prices then fluctuate between the $1900 and $1950 level over the next few months, before sharply selling off at the end of September and start of October to a series low of $1820 at the time when the Israel-Hamas war began. Since then, there has been a sharp rebound to today’s level at $1980, which marks a series high.
That signals some worry, but not necessarily the greater risk of a broader conflict. By comparison, the 1973 Yom Kippur War (50 years ago this month), involved a wider group of nations and resulted in an oil embargo by Arab OPEC countries that had dramatic consequences. That embargo meaningfully disrupted supply, and led oil prices to soar over 300%, inflation to surge, a recession to unfold, and stock markets to fall into a prolonged rout.
Given that there isn’t any evidence of similar actions being taken today, and neither side in this conflict are meaningful oil players, markets haven’t needed to recalibrate.
That said, it’s worth discussing what escalation could potentially look like. Much is unclear, but a wider conflict would bring greater risk. This could, for instance, happen if Hezbollah opens a second front with attacks against northern Israel or if Iran becomes directly involved. On the latter, stricter enforcement of U.S. sanctions against Iran probably wouldn’t bring major risk to oil markets (given, for the most part, global oil supply and demand are pretty balanced, and such enforcement wouldn’t take too much supply offline), but a bigger disruption to important shipping routes like the Strait of Hormuz—which traffics about 20% of global oil consumption—would be much harder to digest.
Iran Oil Production Nearing pre-2018 Levels
’000 barrels per day
In that higher risk scenario, it’s possible other producers could step in to offset some of the supply reduction (but probably not enough to hold oil prices steady). The United States has been rapidly adding supply, and given time, it could add quite a bit more. Adding to this, the relaxation of U.S. sanctions on Venezuela could unlock 200k barrels/day over the next six months, although we’re skeptical of how effective this will be. Guyana is entering stage left, with a massive oil basin believed to hold $1 trillion of oil. This will take years to come online, but some will begin to flow in early 2024. And lastly, remember that Saudi Arabia has been cutting 1m barrels/day in production to support prices since June. This could, in theory, be easily reversed and quickly brought back to market if needed.
When it comes to broader bond and stock markets, different drivers seem more at play.
10-year U.S. Treasury yields surged further this week, and are close to touching 5% for the first time since 2007. Yet, longer-dated bond yields have been climbing since May (well before word of the conflict hit), and a confluence of factors seem to be at play:
- Growth: The U.S. economy grew nearly 5% in the third quarter. The labor market is still humming. The consumer is still spending, and capex around industrial policy is creating powerful tailwinds.
- Monetary policy: Because growth has been strong, and inflation sticky, policymakers have resolutely signalled that they intend to keep rates “higher for longer.” So while the Fed may be done (or nearly done) hiking, the market has moved to reprice fewer future cuts.
- Fiscal deficits: The U.S. Treasury has had to issue more bonds than expected this year to finance the government’s deficit. Now, as President Biden prepares to ask Congress for more funds (in the billions of dollars) to offer aid to Israel and Ukraine, this has been even more in focus.
- Washington dysfunction: It took the House over three weeks to elect a speaker. That doesn’t incite much confidence for policymakers’ ability to tackle both short-term spending needs and long-term debt problems, especially as we barrel towards the November 17th budget deadline to avoid a government shutdown.
- Technical market factors: Positioning, momentum and trend-following strategies all seem to be exacerbating the moves over the last few months.
Bond yields have been driven by a confluence of factors
10-year U.S. Treasury yield, %
The chart describes the yield on 10-year U.S. Treasuries in 2023, with events called out throughout the year.
The line started at 3.87% on January 2, 2023.
The line trends downward, and at the event “February FOMC meeting” the arrow points to a yield of about 3.41% on February 1, 2023.
The line trends upward to the next event “U.S. regional banking crisis” and on March 8, 2023 the yield was 3.99%.
The line trends downward to the next event “May FOMC meeting kickstarts “higher for longer” chatter” and on May 1, 2023 the yield was 3.57%.
The line trends upward to the next event “Bank of Japan loosens its yield curve control policy” and on July 27, 2023 the yield was 3.99%.
The line moves downward to the next event “Fitch downgrades U.S. government credit rating” and on July 31, 2023 the yield was 3.96.
The line trends upward to the next event “U.S. Treasury ramps up issuance” and on August 9, 2023 the yield was 4.00%.
The line trends upward to the next event “September FOMC meeting” and on September 22, 2023 the yield was 4.43%.
The line finishes on October 20, 2023, at 4.93%.
Meanwhile, the S&P 500 is down just over 3% since the conflict began, and is still about 17% higher from the lows hit one year ago.
Digging deeper, valuations started to come under pressure over the summer as bond yields surged. And more recently, the start of the Q3 earnings season seems to be most front of mind. Banks have been better-than-feared, and while tech has been mixed, there have been notable bright spots. In all, we think this quarter will likely mark a return to earnings growth after three straight quarters of contraction.
Earnings expectations have continued to march higher
S&P 500 next 12 months earnings per share (EPS) estimates, $
The chart describes the S&P 500 earnings per share (EPS) estimates since Jan 2022 in $.
The line started at $222.3 on December 30, 2021.
It went all the way up and peaked at $238 on June 23, 2022.
Then it went all the way down and troughed at $223 on February 23, 2023.
Then it went back up again and reached $238 on October 20, 2023.
Piecing it all together, the market seems very much aware of the conflict in Israel and Gaza, and appears to be accounting what’s known so far. That could change if we do see material escalation, but our understanding of how broader markets have behaved around similar geopolitical events suggests that the economic backdrop and business cycle are the key dynamics to monitor.
Investment considerations
Navigating uncertainty
Markets are grappling with a lot of moving pieces, from escalating tensions in the Middle East, to earnings and Fedspeak. In times like these, it can be helpful to remember the power of staying invested, especially with a diversified portfolio. That approach has benefited through countless risks and periods of volatility and we think it can continue to do so.
We continue to think prospects for a soft landing for the U.S. economy have grown, and higher bond yields can do some work to quell the still-too-hot clip of growth and inflation. We also believe that today’s pricing offers one of the better starting points for multi-asset investors we have seen over the last decade. We think equities offer an opportunity here, with more reasonable valuations, positive seasonal trends, and a more constructive earnings picture offering support. And while we can’t rule out further spikes in bond yields, today’s elevated levels seem to be compensating investors for uncertainty. For investors worried about tail risks, equity hedges, as well as investment products in oil and gold, could help protect a portfolio from large geopolitics-induced swings.
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