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Geopolitical unrest: Assessing market implications

April 19, 2024

Some investors worry Middle East tensions could impact inflation, making it tricky for central banks. Top Market Takeaways digs into what we’re watching and what it could mean for investors.

Contributors

Madison Faller

Global Investment Strategist

Matthew Landon

AWM Program Analyst

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 nature of 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 that should remain true.

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 is 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 like 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.

This line chart shows the Brent crude oil price from the start of 2021 to today.

Today, Iran accounts for around 4% of global oil production. As a point of comparison, Russia’s share of global production was almost three times that as it began its war with Ukraine and with far more developed economies reliant on those imports.

This table shows the top 10 oil producers and share of total world oil production in 2023.

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. U.S. 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 (i.e., 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 U.S. 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 that 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 U.S. 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 gross domestic product. 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 (e.g., like shipping and air cargo prices).

Central bankers would need to balance such upside inflation risks with the potential growth headwinds. That 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. That may be as media headlines over the last week – and months – 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 (J.P. Morgan Asset & Wealth Management 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 like 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 vs. ~8% in the 1970s). That 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.

This chart shows the S&P 500’s performance during the 12 months leading up to a geopolitical event and the two years following.

The impact of geopolitics on markets tends to be short-lived

S&P 500 around military invasions and conflicts, month of event = 100

This chart shows the S&P 500’s performance during the 12 months leading up to a geopolitical event and the two years following. The events that are charted are the Korean War (06/1950), Soviets into Hungary (11/1956), Six-Day War (06/1967), Soviets into Czechoslovakia (08/1968), Arab-Israeli War (10/1973), Soviets into Afghan. (12/1979), Martial law in Poland (12/1981), Falklands War (04/1982), US invades Grenada (10/1983), US invades Kuwait (02/1991), Serbians into Kosovo (02/1998), September 11 attack/US invasion of Afghanistan (2001), US invades Iraq (03/2003), and N. Korea sinks S. Korean Navy vessel (03/2010), Russian annexation of Crimea/Invasion of Ukraine (03/2014), Fall of Mosul to Islamic State (6/2014), Russia invades Ukraine (02/2022).

The data series are indexed so that the month the conflict occured is labeled as 100. The y-axis scale goes from 60 to 140. There are two lines highlighted: Arab-Israeli war (1973) and the average.

The Arab-Israeli war line starts around 95 at 12 months prior to the start of the event. It jumps up to 110 before coming back to 100 at the start of the event. From there, the line drops sharply to a low of below 60 around 12 months after the event. Following which it recovers to end the series close to 80.

The average line starts indexed at 95, and as the months pass the line has a slight upward slope until 24 months after the conflict start where the line finishes at 114.

The takeaway is that the equity market tends to move past geopolitical conflicts fairly quickly, unless it results in a global supply shock, as was the case with the OPEC oil embrago in the 1970s. However, it should be noted that oil supplies are much less concentrated now than they were then with the U.S. now a major oil producer.

Sources: J.P. Morgan Asset Management – Eye on the Market (July 2014 edition), Bloomberg Finance L.P. Data is as of October 2023. S&P 500 Index represents price returns. Events include: Korean War (1950), Soviets into Hungary (1956), Six-Day War (1967), Soviets into Afghanistan (1979), Martial Law in Poland (1981), Falklands War (1982), U.S. invades Grenada (1983), U.S. invades Kuwait (1991), Serbians into Kosovo (1998) U.S. invades Iraq (2003), N. Korea sinks S. Korean Navy vessel (2010), Fall of Mosul to Islamic State (2014), Russia invades Ukraine (2022). Past performance is no guarantee of future results. It is not possible to invest directly in an index.

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.

A J.P. Morgan advisor is here to discuss what this could mean for you and your portfolio.

All market and economic data as of 04/19/2024 are sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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Index definitions:

Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941–43 base period.

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Contributors

What happened

What we’re watching

Oil prices remain low relative to 2022 levels

Brent crude oil, price per barrel

Iran accounts for 4% of global oil production

The top 10 oil producers and share of total world oil production in 2023

Investment considerations

The impact of geopolitics on markets tends to be short-lived

S&P 500 around military invasions and conflicts, month of event = 100

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