War in the Middle East

Good morning. I had a different topic planned for today’s post but as is probably true for everyone who’s paying attention, plans changed along with events in the Middle East over the weekend. This is a rapidly evolving situation that sent stock and bond markets down over a percent at the open yesterday. Selling pressure waned throughout the day and major indexes ultimately closed about flat.

As I type this morning, markets opened lower and have declined further (about 2.2%) on news overnight of intensified fighting, missile and drone strikes from all sides, including on the US Embassy in Riyadh, within an operation that could last weeks, according to President Trump.

Markets are squarely focused on impacts to the flow of crude through the Straight of Hormuz, a sea lane where ships carrying roughly 20% of global crude pass by daily. The longer this war lasts, the greater the potential disruption to these flows, and the greater the impact on consumers via higher gas prices and the general inflation that comes with it. Oil prices have risen about 15% since last week to about $77 per barrel as I type. Various analysts suggest that American consumers could handle oil prices of up to about $85 without too much of an increase at the pump, but that will be one of the many issues weighing on markets in the coming days. While it might seem callous to mention such things as bombs are flying and people are dying, and I agree that it is, that’s what investors and by extension markets, are primarily focused on at this point.

So, I wanted to share some snippets from my research partners at Bespoke Investment Group. They do a great job of distilling geopolitical events down to specific points for investors.

From Bespoke…

During the very early hours of Saturday morning Eastern time, the US and Israel launched a fresh wave of attacks on Iran. A state of war now exists between Iran and those two countries as well as Gulf states that host US troops and military infrastructure. Those countries have been targeted by cruise missiles and drones from Iran, which have also been launched at scale towards Israel. As best as we can tell, the US and Israel established almost immediate air superiority over Iran and are for all intents and purposes unopposed as they work their way through lists of targets.

The most important factor for markets is of course petroleum and LNG flows. Since the attack on Friday, Hormuz has been de facto closed with tankers immediately fleeing for the shore. Iranian response strikes appear to have damaged at least three, but we have not seen reports of major damage to permanent carbon fuel infrastructure. A closure of Hormuz for less than a week is not a particularly big blow to global liquid fuels markets...

We have several key points to make as inputs into a framework for how long this conflict lasts.

1. A large number of senior Iranian civilian and military leaders have been confirmed as killed in US and Israeli strikes. That actually extends to reformers and dissidents too, with President Trump saying last night that “The attack was so successful it knocked out most of the candidates [that the US was considering as acceptable leaders]. It’s not going to be anybody that we were thinking of because they are all dead. Second or third place is dead.” There is a significant leadership vacuum inside Iran.
2. It’s still unclear what the US strategy is, in the sense that war aims are constantly changing based on what the President has said publicly. That ranges from a commitment to continue strikes for weeks to discussion of a cease-fire. The IAEA said this morning that nuclear sites had been “largely spared” in the bombing campaign so far.
3. The Iranian responses extremely widespread and low intensity, suggesting that there is no central control or ability to set tactical let alone strategic priorities.

Taken together, these factors suggest increased likelihood of a power vacuum and collapse into civil conflict.

That scenario is also bad news for flows through Hormuz, because security of that passage for oil requires consistent behavior from Iran and that is impossible if any leader is immediately snuffed out by a US or Israeli strike. All of that said, there are certainly relatively benign outcomes possible. Some are outlined below.

1. Strikes against potential leadership (likely conducted by Israel given the President’s comments yesterday) stop, allowing some sort of reform oriented political power to coalesce and negotiate an end to the bombing campaign.
2. Significant civil revolt leads all military assets to be directed internally instead of externally, making Hormuz less dangerous to transit regardless of internal stability.
3. Iranian forces lose the ability to project power over any distance including into Hormuz, either due to attrition or exhaustion of consumables.
4. The President de-escalates by slowing or halting the bombing campaign, leading to another round of peace talks and normal activity in Hormuz.

The problem is that the use of drones and cruise missiles as primary weapons in Iran’s response campaign means that it doesn’t take much to keep Hormuz far more dangerous than the risk tolerance for tanker operators (extremely low) will allow. The fact that the response from Iran has been so widespread against Gulf states (including civilian targets), that peace negotiations were apparently used by the US as cover to prepare for the strike, and that so many potential leaders of a domestic revolt against the current regime have been killed, and the massive blood-letting of potential energy to overthrow the regime during December-January suggest that a domestic uprising may be unsuccessful.

*** And a final note from me… investment-wise it’s important to remember that this is happening within the context of a healthy economy with no near-term risk of recession. One analysist referred to the US economy as a “healthy tortoise”, and I think that’s appropriate. Among other things, this means we can weather many of the assumed potential economic impacts from a “short” war in the Middle East. We’ll all have to watch as events unfold and how they impact markets, but I’d be very careful about making major portfolio changes around this evolving situation.

Anyway, there’s more to come in the days and weeks ahead, so please reach out if you have questions about your situation.

Have questions? Ask us. We can help.