Conflict in the Middle East: What could this mean for financial markets?

Conflict in the Middle East has often been a source of considerable financial market and economic disruption.

In 1973 an oil embargo by the Organisation of Arab Petroleum Exporting Countries triggered huge inflation and historically large declines in the value of savings. A second oil shock of the 1970s followed the Iranian revolution. Both events saw oil prices ultimately tripling at a time when the global economy was very dependent upon oil.

The Gulf wars of 1990 and 2003 also shook the economy and triggered inflation, although their impact was considerably less. The last few days have seen a resumption in the tensions that began decades ago and have been gradually re-intensifying over the last two years.

How have the markets reacted?

It’s natural to be concerned whenever there’s military conflict anywhere in the world, however from an investor’s perspective, it’s also important to recognise that markets can take a dispassionate, analytical, and probabilistic view of world events.

Ideological battles and casualties are sometimes viewed through the prism of their impact on the economy. The question of how this escalation will impact the markets is largely a reflection of how it will impact the flow of energy assets from the gulf to the wider world, and to a lesser extent whether there’ll be disruption to the flow of trade through the Suez Canal.

At present, the conflict remains contained in a way which might not threaten the global economy. So, what’s so different about this conflict compared with those that have gone before? To answer that question, there are a number of issues to consider.

Will the conflict cause significant disruption of energy supply?

It’s possible, but this time the circumstances are different. Iran’s share of global energy production has fallen from 10% to around 4%, partly because of increasing production in other regions. Iran is also ostensibly subject to stringent sanctions, although it manages to evade these through various mechanisms which allow it access to non-western markets, most notably China.

Could other parties be drawn into this conflict?

Unlike the 1970s energy disputes when the protagonists were partly proxies in the broader Cold War, this dispute is currently between Israel and Iran. The current U.S. Secretary of State, Marco Rubio, has been keen to emphasise that Israel acted unilaterally. Iran has rejected those claims of non-involvement, but its distrust has not led it to take reprisals against the U.S., and the case for doing so is weak. Most obviously because the U.S. is a vastly more powerful military force than Israel acting in isolation, so the potential benefits to Iran from engaging the U.S. seem vanishingly small.

One of the most frequently discussed paths to escalation which is available to Iran would be to disrupt the Strait of Hormuz, the 90-nautical-mile-long channel, bordered by Iran along its north coast, which is just 21 miles across at its narrowest point. RBC’s Head of Global Commodity Strategy, Helima Croft, understands that this would not be possible for an extended period due to the U.S. Fifth Fleet currently stationed in Bahrain.

Would fellow Arab states join with Iran in this dispute?

Iran has become an increasingly isolated state on the geopolitical scene. There seems little desire on the part of other cash-strapped OPEC members to suffer the lost revenue of cutting oil production to support the Iranian cause, even if they did view other countries as being complicit. Relations between Middle Eastern countries have always been complex and Iran, as an Islamic republic with a largely Shia population, shares as many contrasts as it does similarities with regional peers.

How could this conflict ultimately be resolved?

The most recent attacks by Israel on Iran targeted Iran’s nuclear infrastructure with the intention of preventing it from being able to produce a nuclear weapon. Israel has caused severe damage to two key Iranian nuclear facilities − Isfahan and Natanz. Both sites are involved in the series of steps required to build a nuclear weapon, so the Israeli attacks will have disrupted Iran’s nuclear supply chain.

Israel also targeted the Fordow fuel enrichment plant. But it was unable to do any meaningful damage as it doesn’t have the sufficiently large bombs required to impact facilities located as deep below ground as Fordow. This is important because in 2023, the International Atomic Energy Agency found uranium particles enriched to 83.7% purity at Fordow, near to the 90% level needed to make a nuclear bomb. On Friday, various experts made statements to the effect that as long as Fordow remains operational, Israel’s attacks just slow Iran’s path to the bomb.

We understand that Israel would be unable to significantly damage Fordow without U.S. involvement. Therefore, while the U.S. remains uninvolved, Israel would seem to be committing to an ongoing indefinite campaign to slow Iran’s progress to nuclear weapon development, rather than achieving a knockout blow.

After the initial attacks on the nuclear facilities, Israel has now hit energy infrastructure in the form of a fuel depot, an oil refinery, and a natural gas plant linked to its massive South Pars gas field. Iran doesn’t export much natural gas, and these attacks will hurt Iran’s domestic energy supply more than anything.

This action would be consistent with a strategy of attempting to capitalise on the unpopularity of the Iranian leadership and a possible succession crisis which may ensue due to the age and frailty of Supreme Leader Ali Khamenei. While there’s evidence of significant support within Iran for democratic reforms, and it may seem to present an obvious stepping off point for Iran’s nuclear ambitions, recent years have shown how difficult it is to predict how states will evolve following regime change.

How should investors respond?

There’s an adage that says investors should “buy on the sound of gunfire.” It seems unintuitive, but as with all such sayings, there may be some wisdom contained within. In this case, the suggestion is that the sell off which greets an outbreak of war, can be an opportunity for investors to benefit from the fear and uncertainty such events bring.

This is very often an appropriate approach to investment, however in this case there’s a significant nuance. So far, financial markets have treated this hostility as an economically benign event and so no obvious opportunity has presented itself. Markets don’t seem to expect Iran to try to broaden this conflict by either attacking western targets or disrupting energy exports via the Strait of Hormuz, because to do so would likely spell the end for the regime.

In conclusion, the situation is certainly concerning, but to derail the economy this situation would need to escalate significantly.

The value of investments, and any income from them, can fall and you may get back less than you invested. This does not constitute tax or legal advice. Tax treatment depends on the individual circumstances of each client and may be subject to change in the future. You should always check the tax implications with an accountant or tax specialist.  Neither simulated nor actual past performance are reliable indicators of future performance. Investment values may increase or decrease as a result of currency fluctuations. Information is provided only as an example and is not a recommendation to pursue a particular strategy. Forecasts are not a reliable indicator of future performance. We or a connected person may have positions in or options on the securities mentioned herein or may buy, sell or offer to make a purchase or sale of such securities from time to time. For further information, please refer to our conflicts policy which is available on request or can be accessed via our website at www.rbcwealthmanagement.com/en-uk. Information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness.

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