Geopolitical unrest: Assessing market implications

Tensions in the Middle East have escalated over the last week.

While it feels difficult to do so during times like these, our job as investors is to assess what impact the conflict might have on the global economy and financial markets, and then determine if we need to change the advice we are giving about portfolios.

The message: Risks are higher than before, but so far, these most recent events do not derail our constructive view for the year ahead. There may be volatility as investors wait to learn more, but in our opinion, the actions taken thus far seem designed to avoid material escalation. The market reaction has been on edge, but notably muted.

This is not the first time geopolitical turmoil has been the catalyst of turbulence for investors. In the end, staying invested in a diversified, goals-aligned portfolio has benefited through countless geopolitical crises, wars, pandemics and recessions—and we believe this should remain true today.

What happened

Since the Israel-Hamas conflict began in October, tensions have brewed as key actors react to the evolving situation. Last weekend witnessed a significant drone and missile attack by Iran against Israel, in retaliation for a strike on its consulate base in Syria. The world held its breath, awaiting Israel's response. Early Friday, Israel retaliated with a military strike on Iran. While the situation remains highly uncertain, Iran appears to be downplaying the incident, with a top official stating no immediate plans for retaliation.

The events mark a clear escalation of tensions in the region, but it’s worth noting that the attacks over the last week seem calculated to avoid intensifying the conflict while still demonstrating resolve.

In all, the geopolitical backdrop remains uncertain and carries more risk than it did before, but so far, there appear to be arguments against a wider conflict.

What we’re watching

Nerves seem tempered for now, given the nature of the events and Iran’s de-escalatory statements, but uncertainty remains. If the parties don’t escalate further, and the conflict remains contained, global investors are likely to revert to the status quo, with the economic cycle in the driver’s seat and geopolitics a tail risk. But if the conflict escalates into one with a larger geo-economic footprint (particularly through involvement of more parties or a closure of the Strait of Hormuz), more careful analysis will be required.

To do that, we are watching three main areas: 1) the impact on natural resources, 2) the effect on the economy (especially inflation), and 3) the follow-through into price action.

1) Impact on natural resources

The gist: Iran itself is a smaller oil supplier, but the potential for conflict spillover into the broader region and/or disruption of significant transit routes such as the Strait of Hormuz pose greater risk. Oil prices are likely to reflect some of these risks in the coming months, but we think we’d need to see meaningful escalation to see a pronounced spike to the 2022 highs of $125/barrel.

However, two risks stand out:

• The risk of a broader conflict. The Middle East as a whole accounts for roughly a third of global oil production. Should others in the region start to take sides, the energy supply picture could look more difficult.
• The risk of transit disruption. Here, the Strait of Hormuz sees almost 20% of global oil supply and a significant amount of all shipping volumes. Iran’s geographic proximity to the channel poses a risk of immobilizing supply with a global impact.

To us, both risks appear contained for now. The United States and European nations have been clearly against actions that could lead to wide-scale escalation. Iran’s own reliance on the Strait of Hormuz also makes its closure seem less likely—with severe consequences for its already struggling economy, as well as for Arab Gulf states broadly and China (Iran’s largest trading partner).

If we see a pronounced disruption, it’s worth noting that there seems to be room in the energy supply chain to deal with a shock. Such events would likely prompt some oil producers to bring additional supply online: OPEC+ producers have spare capacity, and the United States has also shown a proclivity to step in. Higher prices would likewise deter consumers, leading to demand destruction—we’ve already seen evidence of this as oil began its climb in late January. Those combined dynamics could partly—but not fully—counteract a geopolitics-driven surge.

2) The effect on the economy—especially inflation

The next logical question is what a surge in energy costs could mean for inflation. And with central bank rate cuts already a debate, what might this mean for monetary policy?

Drawing on our recent analysis of inflation, the pass-through effect of higher energy costs into consumer prices differs across regions. In North America—where economies are predominantly energy independent today—the potential impact appears less severe. Our analysis, which uses data back to 2000, implies that a surge in oil prices to their $125/barrel peak would result in a less than one percentage point spike to “non-energy” inflation. When it comes to growth, some comfort might also come from the fact that the United States is less energy intensive than it used to be: Compared to the early 1970s, it now takes over 70% less oil to generate one unit of GDP. In Europe, the inflation and growth impacts would likely be bigger.

Outside of energy prices, obstruction to global supply chains via the Strait of Hormuz could add pressure to goods prices (which have been deflating over the course of the last year) as companies try to pass on higher input costs (such as shipping and air cargo prices).

Central bankers would need to balance such upside inflation risks with the potential growth headwinds. This would be tricky to navigate, but so long as there is not a genuine reversal of disinflationary trends, we don’t think policymakers would be forced to return to rate hikes.

3) The follow-through into price action

So far, the market moves have been muted in the face of the recent events. This may be as a result of media headlines over the last week—and months—which have enabled investors to account for the risks. As Friday trading begins, oil prices are off their highs and back below $90/barrel, bond yields are lower, and stocks are just modestly down.

Outside of the immediate market reaction, it’s worth noting that the nations at the center of the conflict represent a small proportion of the global stock market: Israeli shares account for just 0.18% of the MSCI All-Country World Index, and the Middle East as a whole is 1%. Disruption in these economies alone also doesn’t seem a hindrance to earnings: S&P 500 companies derive just 0.2% of their revenues from Israel.

The risk, of course, is again more meaningful escalation that leads to inflation volatility and macro uncertainty that upends sentiment and business investment. But the fundamental backdrop for investors remains unchanged with the situation as it stands.

Investment considerations

Geopolitical threats are important for investors to consider and prepare for—a key point made in our CEO Jamie Dimon’s 2023 Annual Shareholder Letter. Already, economies are reorienting supply chains and increasing defense spending to bolster their security.

As we look forward, no one has a crystal ball—but history has taught us a few lessons on navigating events such as these. Drawing on the seminal work of Michael Cembalest (AWM Chairman of Market & Investment Strategy), the business cycle mattered more for investors in the majority of the geopolitical events in post-war history he examined. Barring a major economic disruption or imbalance as we outlined above, the effect of geopolitics on markets has tended to be short-lived.

In his analysis, the 1973 Arab-Israeli War was one of the notable exceptions, as an OPEC oil embargo led to a surge in oil prices, high inflation, an economic recession and a prolonged rout in stock markets. So far, there isn’t evidence of similar actions being taken today. The world is also very different today than it was then: The United States now produces more oil than it consumes, and energy makes up roughly half as much of the average American’s spending than it did back then (4% today versus ~8% in the 1970s). This means the inflationary impact of a potential escalation now would likely be more contained versus that episode.

The key takeaway: Staying invested in a diversified, goals-aligned portfolio has paid off through countless geopolitical crises, wars, pandemics and recessions, and will likely continue to do so.

Finally, with uncertainty high, it can help to focus on the fundamentals. Today’s backdrop of sticky inflation (see last week’s U.S. CPI print), debate about rate cuts and election mania must also be taken in balance with a robust labor market, a still-strong consumer, resiliency in corporate America, and fiscal spending efforts around industrial policy and AI that are doing real work to innovate, grow and transition the economy. We still see a soft landing for the U.S. economy as more probable than not, and Europe and Japan are in the midst of their own economic recoveries.

So while there are undoubtedly risks, we continue to believe there’s good value in the market based on what we know today.

Your J.P. Morgan team is here to discuss what this means for you and your portfolio.