With limited foreign reserves and a weak economy, Iran can barely afford further economic sanctions.
If tensions were to re-intensify, resulting in a meaningful disruption to oil supplies, the magnitude of the global economic impact would depend on how far, and for how long, oil prices rise.
Markets may be breathing a sigh of relief over this week's signing of a U.S.-China trade deal.
By Seema Shah, Chief Strategist, Principal Global Investors
Just as the two key risks of 2019 - U.S.-China trade tensions and the endless Brexit saga - seemed to resolve themselves, another geopolitical shock struck global markets. The assassination of a renowned Iranian general via a U.S. drone strike, followed by a threat of "severe retaliation" by Iran's supreme leader, Ayatollah Ali Khamenei, triggered the risk-off market moves.
Yet, in contrast to some rather feverish media headlines, market moves were more muted and short-lived than those following last year's Iranian strike on a Saudi oil facility. Within a week of this latest attack, with no impact on global oil supply, equity markets had hit new heights and oil prices had retreated below their levels just prior to the assassination.
What's more, the Volatility Index (VIX) remained steadfastly below 20 throughout the whole episode, reflecting the fact that both sides had strong incentives to de-escalate tensions. Indeed, with limited foreign reserves and a weak economy, Iran can barely afford further economic sanctions. Meanwhile, in the United States, polls showing that war would be very unpopular among the American electorate must be a strong deterrent for President Trump.
And yet, the respite can only be described as fragile. While geopolitics is difficult to predict at the best of times and both sides have reason to avoid further turmoil, if history tells us anything, enduring peace between the U.S. and Iran is unlikely.
If tensions were to re-intensify, resulting in a meaningful disruption to oil supplies, the magnitude of the global economic impact would depend on how far, and for how long, oil prices rise. From our own forecasts, an increase in oil prices back to the $70 level would be digestible, but a further $10 increase starts to become problematic as energy would then weigh on global household purchasing power.
And, even considering the fact that, as a net exporter of petroleum, the U.S. is less exposed to oil price shocks, the repercussions for global markets could be significant.
While equity markets are at record highs, the economic outlook is less impressive. We expect the global economy to stabilise in the first quarter of this year, but we don't anticipate a particularly vibrant upturn. In our baseline scenario, persistent central bank liquidity should continue to support stocks, even though this lacklustre backdrop. But the growing disconnect between expensive valuations on one side and only modest economic growth on the other undoubtedly renders equities vulnerable to a deterioration in sentiment. A sharp and persistent oil price spike has the potential to disrupt the positive returns we expect for equities in 2020.
Investors may want to hedge themselves by increasing exposure to the energy sector. Not only is it more attractively valued than other sectors, but the energy would surely outperform in the event of a disruption to oil supply. What's more, even if geopolitical risks fail to materialise, the expected global growth recovery should also put upward pressure on oil prices. Energy should deliver in both positive and negative scenarios this year.
And of course, the U.S.-Iran dynamic isn't the only geopolitical risk that investors should be wary of. A "shock" outcome in the U.S. presidential elections later this year; renewed U.S.-China tensions; and a repricing of "no-deal" Brexit risk are just some of the political dynamics that could threaten markets this year. So, although the economic outlook is more promising than in 2019, thereby making a clear case for increasing exposure to cyclicals, the potential collision of elevated valuations and geopolitical risk means that investors should also maintain at least some defensive positioning.
Markets may be breathing a sigh of relief over this week's signing of a U.S.-China trade deal. But the geopolitical risk is not dead. The U.S.-Iran conflict should be a sharp reminder that tail risks still exist.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.