Israel-Hamas conflict: potential market implications

The conflict between Israel and Hamas enters its second week. As our thoughts go out to the many victims and people suffering, our job is to consider different scenarios and potential effects on client portfolios. Creating scenarios in such a complex geopolitical situation is challenging, and we’re wary of being too precise in assessing the outlook.

As we’ve noted before, we think financial markets have often been able to look past a lot of geopolitical risks in recent years. On this occasion, however, the crisis has reached a point at which we do see financial assets reacting. In simple terms, we see risky assets like equities weakening, while commodities like oil and gold, in particular, have risen. But the Middle East crisis isn’t the only thing driving financial markets. We’ve seen government bond yields in the US for instance drifting higher – and not so far providing the sort of safe haven returns that some might have expected. While equity investors continue to focus on the outlook for growth in the context of higher interest rates.

At this point, we are considering three broad scenarios. First, a restricted crisis – where the conflict remains limited to Israel and Gaza. Second, a wider regional crisis, perhaps directly involving Iran and the US. Third, some sort of de-escalation to the current conflict. 

The first two scenarios most likely produce continued caution in markets – risky assets like equities would remain under pressure, while some commodities like oil and gold could benefit. We think that some of that is already reflected in asset prices – particularly the price of oil. But, if a regional conflict becomes more likely, we would expect to see a greater impact on financial assets, as commodity prices rise further and investor sentiment deteriorates.

One interesting topic is how government bonds could behave. In theory, in a so -called “risk-off” scenario, we might expect safe assets, like government bonds, to benefit. We may have seen some of that, but bond yields have generally risen over the past few days. 

We’d argue that reflects a few important considerations. Inflation remains quite high in developed markets. UK inflation came out this week at 6.7% year-on-year – still far above the Bank of England’s 2% target. 

Rising oil prices are likely to complicate that even further. It will make life harder for Central Banks whose mandate is focused on domestic inflation rather than reacting to geopolitical shocks. Yield curves are still inverted, so you still get paid more to own short-dated government bonds. So we think that government bonds will do better than risky assets, but we’re still a little cautious about buying more longer-dated bonds. 

In terms of our scenarios, today, we think we’re currently sitting somewhere between scenarios 1 and 2. The conflict on the ground continues and the prospect of a regional crisis is still very present. We’ve seen signs of escalation across the region in the past couple of days. 

We are hopeful that we will see de-escalation at some point, and the press is full of reports of negotiations across the region. From a financial markets perspective, the question is from what level of conflict and disruption will we see that de-escalation occur. The risk is that we will see greater violence and suffering before that point, with a knock-on effect for financial assets. In a de-escalation scenario, we’d expect to see risky assets rally and most likely, a pull-back in gold and oil. 

What about portfolios? We think that our portfolio positioning looks reasonable in the current traumatic period. Compared to our internal benchmarks, we are underweight equities, overweight government bonds (more short-dated) and we continue to hold some broad commodity exposure. We think that’s a prudent allocation at this point.

What about the future? Geopolitical risks are rising around the world – from Russia-Ukraine, the Middle East, Armenia and Azerbaijan. We suspect that these risks will get more attention from investors going forward, even if the current crisis in the Middle East does de-escalate in some way. That has important implications for portfolio construction. We think it probably means higher market volatility going forward and it reinforces the case for well-diversified portfolios.