MW Latest threat to stock-market rally? Investors suddenly fear geopolitical risks.
By Joseph Adinolfi
Concerns about a potential Iranian retaliation against Israel added to the week's rout in stocks
Investors seemed perfectly content to ignore geopolitical risks for most of the past year.
But that appears to have changed as of Thursday afternoon in New York, according to analysts at Bespoke Investment Group, who pointed to speculation that Israel may be bracing for a military strike from Iran as a catalyst for a violent reversal in stocks.
Israel had demolished an Iranian consulate in Syria earlier in the week, which helped push crude-oil prices higher.
Some market analysts now caution that the powder keg in the Middle East ultimately could cause more harm to stocks than a delayed start to the Fed's interest-rate cuts, potentially becoming a rare example where geopolitical risks have a lasting impact on markets.
"Equity investors are not particularly good at assessing geopolitical risk and how it might impact markets," said Steve Sosnick, chief market strategist at Interactive Brokers, during an interview with MarketWatch. "It's one of those things it tends to be in the background until suddenly it isn't, then sometimes we get an overreaction when they do start to pay attention."
While U.S. equity gauges ended higher Friday, they tumbled Thursday afternoon, with the Dow Jones Industrial Average DJIA surrendering a sizable gain to finish 530 points lower, its biggest daily decline in more than a year, according to Dow Jones Market Data.
Treasury yields moved higher Friday, but were lower Thursday, despite comments from Federal Reserve Bank of Minneapolis President Neel Kashkari, who raised the possibility that the Fed might leave interest rates on hold until next year. To the team at Bespoke, the muted reaction in bond yields was a sign that fears about an Iranian escalation, not the shifting outlook for interest rates, were the main culprit for the selloff in stocks.
In light of this, it is worth examining why stocks suddenly appear to be reacting to tensions between Iran and Israel six months after the start of the Israel-Hamas war. Equities initially shrugged off the Oct. 7 Hamas attack, with the S&P 500 SPX finishing higher on Oct. 9, according to FactSet data.
One reason investors tend not to react to geopolitics is that they rarely have a lasting impact on corporate earnings, according to Savita Subramanian, head of U.S. Equity & Quantitative Strategy at BofA Global Research, who discussed the topic in a report published shortly after Hamas attacked Israel on Oct. 7. Unless geopolitical shocks impact the underlying economy, the resulting market selloff tends to be short-lived, presenting an opportunity for investors to buy the dip after a selloff of between 5% and 10%, she said.
Major geopolitical events of the past three decades, including the Sept. 11 terrorist attacks and the U.K.'s vote to leave the European Union, had only a fleeting impact on markets, Subramanian pointed out.
Even the shock of Russia's war with Ukraine faded as crude-oil prices retreated from their peak around $130 a barrel. The Fed has identified supply-chain issues caused by the COVID-19 pandemic as the primary driver of the inflationary wave that rocked markets in 2022, while the Biden administration initially blamed Russia.
Yet any broader conflict in the Middle East involving Israel and Iran could produce a level of economic blowback that might force investors to react.
A spike in crude-oil prices, given the Middle East's large production operations, could be an obvious pain point. While ample U.S. crude supplies should soften the blowback on U.S. consumers, Subramanian pointed out that corporate profits for U.S. multinationals could suffer from further disruptions to global trade, falling demand for overseas travel, and a weaker European consumer if another energy shock arises, pushing Europe into a recession.
All of these factors could depress global stocks for longer than a few months, Subramanian said.
To be sure, there are areas of the market that could benefit, like the defense and aerospace industry. The SPDR S&P Aerospace & Defense ETF XAR has gotten off to a muted start in 2024, up just 1.7% year-to-date Friday. Energy companies could also benefit from higher crude-oil prices.
Ed Yardeni, president and chief market strategist at Yardeni Research, has long warned that investors shouldn't play down the risks of conflict in the Middle East. He has identified the potential for a regional war as a primary risk to his generally bullish outlook on markets.
Yardeni was back with a fresh warning Friday, saying that if tensions between Israel and Iran metastasizes into a broader conflict, the 2020s could ultimately resemble the 1970s, a notoriously poor decade for stock-market performance, in a client note.
"Historically over the years, geopolitical crises have been opportunities to buy. But this crisis in the Middle East isn't going away, it is getting worse," Yardeni said in an interview with CNBC late Thursday.
U.S. stocks closed higher Friday, with the S&P 500 up 57 points, or 1.1%, finishing at 5,204, while the Dow Jones Industrial Average gained 0.8% and the tech-heavy Nasdaq Composite COMP was rose 1.2%.
All three indexes still finished the week lower, with the Dow posting its worst week in a year. Rising crude-oil prices and higher Treasury yields over the past week also received blame for the recent pullback in stocks.
Yardeni sees the risk of a broader conflict in the Middle East as an even bigger threat to markets than the Fed opting to keep interest rates on hold for the rest of 2024.
"Geopolitics is my No. 1 concern. I will not be concerned if the Fed doesn't lower interest rates because that will be consistent with my view that the economy is resilient," he told CNBC.
-Joseph Adinolfi
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(END) Dow Jones Newswires
April 06, 2024 08:00 ET (12:00 GMT)
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